Avoiding Another Lost Decade (2008-10-27)

Avoiding Another Lost Decade

(2008-10-27) by David John Marotta

Many investors are panicking. From its peak in March 2000, the major market indexes still show significant losses. Even looking back over the past 10 years provides little comfort. The news media is calling it "the lost decade."

The lament began with a front-page Wall Street Journal article in March of this year that noted the S&P 500 had only gained 1.3% over the past 10 years, factoring in inflation and dividends. Since then, the market has continued to lose ground, leaving investors depressed and discouraged about their investments.

Many proactive investors experienced an even larger drop when in their scramble to beat the markets, they sold what had just gone down to purchase what was just about to go down. Chasing returns often amplifies losses and volatility, so much so that many investors believe they are cursed with the reverse Midas touch: What they bought must go down.

As if to add to the misery, many buy-and-hold investors did not even receive the flat market return. They thought they were purchasing actively traded funds, but they were simply buying closet index funds with overly inflated expense ratios. Excessively loaded fees sapped value from their investments while the underlying strategy went nowhere.

I've said before that we do not recommend S&P 500 index funds. Because the S&P 500 is a capitalization-weighted index, it tends to buy more of a stock when it goes up and hold less of a stock when it becomes more reasonably priced.

If the S&P were a financial advisor it would say, "Let's buy mostly large-cap growth stocks in the industry that did well last year with a high price per earnings ratio." The result of this advice is a very aggressive and volatile portfolio that does better at the end of a bull market than at the beginning. And it performs very poorly at preserving capital during a bear market--exactly what has happened over the last decade.

If you are invested primarily in funds that mimic the S&P 500, a lost decade should be no surprise. If we use market history to run hundreds of Monte Carlo simulations on a portfolio invested in an S&P 500 index fund, projections indicate returns at or below zero about 6% to 7% of the time. This scenario is astonishingly accurate of trends in the past 100 years in which six ten-year periods showed no gains. These periods were the 10 years ending in 1914, 1921, 1932, 1938, 1974 and 1977.

If you were invested in the Vanguard 500 Index, your 10-year average return through the end of last month was 3.06%. Inflation during the past decade officially averaged 3.0%, although actual inflation was probably at least 5%. To make matters worse, your portfolio has dropped again this month. So if you were invested in an S&P 500 fund, your decade-long progress toward your retirement goals is at a standstill.

But if you were smart, you did not lose this past decade. If you were invested in a balanced portfolio, you experienced both higher returns and lower volatility.

Even a balanced portfolio of just six different common funds could have boosted your 10-year average return to 8.18%. And it would have lowered your volatility from a standard deviation of 14.4% to only 12.3%. That is a 5.12% better annual return with 2.1% less volatility.

The balanced portfolio I used as a comparison doesn't cherry-pick investments that have done the best recently. In fact, this portfolio underperformed the S&P 500 by 7.5% over the past quarter. Asset allocation means always having something to complain about.

My comparison portfolio allocates 20% to fixed income in the Vanguard Total Bond Index (VBMFX). Of the remainder, it allocates 31% to U.S. stocks with 21% in the Vanguard 500 Index (VFINX) and 10% in the Vanguard Small Cap Index (NAESX). Another 31% goes to foreign stocks with 21% in Vanguard Total International Stock (VGTSX) and 10% in the Vanguard Emerging Market Index (VEIEX). Finally, an 18% allocation is made to hard asset stocks in the T. Rowe Price New Era Fund (PRNEX).

The funds just described have been popular for over 10 years. They have not made their gains from active trading. And they have low expense ratios. These are not necessarily the best funds; they are simply typical funds in each of the asset classes.

Theory and practice agree that a balanced portfolio is a far superior way to meet your financial goals. In Monte Carlo simulations, balanced portfolios earn money over a decade, even the bottom 5% of random returns. The exact portfolio construction is less critical than including asset categories with a low correlation to the S&P 500. A well-balanced portfolio should result in good returns with lower volatility. Returns will still vary widely because the markets are inherently volatile, but the worst cases should be considerably better.

In conjunction with my recommendation of a diversified portfolio, the markets continue to provide object lessons and practical labs. Recently foreign stocks, emerging markets and hard asset stocks have all corrected more than U.S. stocks and are trading at valuations that make them an attractive way to diversify your portfolio. Holding on to an undiversified portfolio will, on average, keep on providing inferior returns with high volatility. Don't wait for an undiversified portfolio to recover. You can't afford to miss another decade.

from http://www.emarotta.com/article.php?ID=307

Part 2: Privatization Could Fix Social Security (2008-10-20)

Part 2: Privatization Could Fix Social Security (2008-10-20)

by David John Marotta

Between 2037 and 2075, the Social Security program is projected to run deficits totaling $30 trillion. And annual shortfalls could be a problem as soon as 2017.

Privatizing the system could break the political deadlock between cutting future benefits and raising payroll taxes. We can have both our benefits and lower taxes if we finally admit that socializing retirement was a mistake and once again trust in the power of free markets.

For some people, the current volatility and decline in the stock market makes the best case against privatizing Social Security. Why would we want to inflict market shocks on every American's retirement? Isn't Social Security at least secure? Unfortunately, it is not.

Computing a return on Social Security as though it were an investment is difficult but not impossible. For example, my average annual return is about negative 7%. It is so poor for three reasons. First, average lifetime annual incomes above $60,000 produce miserable returns. Second, because I fall at the end of the baby boomers, my Social Security withholdings are at the current high rate of 12.4% rather than the lower rates that might have produced a better return. Finally, for those born my year (1960) or later, the age to receive full Social Security retirement benefits was raised from 65 to 67, further lowering returns.

A negative 7% return is huge. That's like investing $100 and 30 years later getting back $11, or investing $100 a year over 30 years and getting back $1,177 of your $3,000 investment. If recent shocks in the stock market seem difficult, imagine losing 60% of value over 30 years of investing!

Not everyone's return on Social Security will be as bad as mine. On average, Social Security provides a return of about 1.2%. If you don't work and therefore haven't paid into the system, your return is a complete gift.

As a comparison, the S&P 500 closed at a low on October 10, 2008, at 899.22. It closed exactly 30 years earlier on October 10, 1978, at 104.46. Even with the recent losses, investments in the S&P 500 have gone up 8.61 times, reflecting an average annualized return of 7.44%. Bond investments show a similar return with much less volatility. In fact, nearly any kind of investing has done better than the return within Social Security.

Proponents of the system view the redistribution of wealth from workers to retirees as positive. They believe we should pay whatever it takes to preserve the program in its current form. That the system destroys wealth and property rights is ignored because the system impoverishes the elderly more equally.

The proposal for privatizing Social Security is simple but elegant. Allow younger workers to deposit part of their Social Security taxes into a private account. If it produces a better retirement than Social Security, they can refuse Social Security and keep the private account. Otherwise they can take Social Security. Given my expected rates of return, putting just a tiny fraction of my withholding into a private account will do better than getting a negative rate of return in Social Security, even using the poor rate of return to where the market bottomed.

For more typical people who might receive the equivalent of a 1.2% return on their Social Security, they would get just as much benefit earning 7.44% on a third of the contributions. Thus 4.1% invested privately could do the job that 12.4% in Social Security can't seem to do without massive deficits. The proposals for privatization suggest allowing younger workers to invest 5% on their own. The other 7.4% would continue to be confiscated to pay aging early baby boomers the normal Social Security entitlement. A few years of deficit spending will be necessary before private accounts begin to relieve the deficit. But ultimately, private accounts will yield a greater benefit than Social Security ever provided. And when the baby boomers are off the Social Security dole, tax rates could be reduced to 5%.

Rather than relieving the problem, raising taxes exacerbates the inequities of Social Security and sends the average returns negative. Additionally, no matter where they are found, the higher taxes required to bail out Social Security would stifle economic growth. Most of the solutions that propose raising taxes result in top margin rate increases of over 15%. This level of curtailing freedom would kill economic growth and innovation.

Of course, cutting benefits is hardly a more attractive option.

Interestingly, either increasing taxes or reducing benefits sets the bar lower for private accounts to beat by any comparison. Privatization simply eliminates benefits for all the workers who can do better with 5% of their payroll taxes than the government does with the entire 12.4%.

Some people like the idea of using the growth engine of private accounts. But they suggest the government maintain control of the money. They would allow the government to invest retirement accounts directly in the private markets. So the government supposedly would protect citizens from their own ineptitude.

Others suggest that governmental involvement and oversight in the financial markets would bring a welcome measure of accountability to corporate America. They favor the so-called good intentions of politicians over the greedy motivations of the financial world.

Although tempting, this idea would be disastrous for freedom and for free markets. Even Alan Greenspan, former chair of the Federal Reserve, warned that governmental investing would "have very far reaching potential dangers for a free American economy and a free American society."

With private Social Security accounts, millions of workers would make independent investment decisions. But if the government took it on, the impact would be unified and rigid. And concentrating that power in a single government entity would magnify its effect. Having a Social Security trust buying and selling in the markets would be like turning on every electrical appliance in your house at the same time. The government retirement monopoly would short-circuit the free markets.

Overnight the government would have a controlling interest in virtually every major company in America. We should have learned from the scandal of political appointments to Fannie Mae and Freddie Mac that political power breeds political corruption.

The federal system would become swamped with feel-good laws requiring investments designed to stimulate the economy, create jobs or develop alternative energy sources. Federal advisors would shun investments that did not pass the litmus test of political correctness.

Some have suggested limiting the government's investments to passive index funds. But that leaves unanswered the question of which indexes will be used and in what percentages. Would all the investments be in U.S. stocks and bonds? If so, the resulting asset allocation would only use two of the six asset categories we recommend.

Ironically, the goals of collectivism are best achieved by respecting individual liberties. When well-intentioned bureaucrats force choices on workers, the incentive for innovation and risk vanishes. As a result, society hardens into a rigid structure that cannot easily align itself with changing market conditions.

Collectivism starts with the premise that the common people cannot be trusted to make their own choices. Once you have accepted that premise, you will take whatever you need and give whatever you want without regard for individuals who would have done otherwise.

Acting on behalf of a collective often justifies imposing our priorities on individuals. For example, if the few in charge believe that foreign investing costs American jobs, they will not allow us to invest overseas. Or if they believe that companies who develop alternative energy sources are a good investment, they will force us to invest in them.

We certainly know by now that not even smart people can force the markets to behave in a certain way. You might as well pass laws outlawing hurricanes.

These are some of the socialistic assumptions that caused the current Social Security system to fail. Privatized accounts could turn that around. It would be a shame to make the same mistake a second time and destroy the engine of capitalism in the process.

Privatization uses the strength of America's capitalist engine to solve the weakness of socialized retirement. Do your part by asking your senators and representative to support privatizing a portion of Social Security. And then assure your own retirement by saving 15% of your take-home pay regardless of what happens in Washington, D.C.



from http://www.emarotta.com/article.php?ID=306

Part 1: Social Security Is Still Broken (2008-10-13)

Part 1: Social Security Is Still Broken

(2008-10-13) by David John Marotta

If you think the $700 billion bailout of the mortgage crisis was expensive, wait until we need to bail out Social Security. Between 2037 and 2075 the Social Security program is projected to run deficits totaling $30 trillion. And annual shortfalls are projected to start as soon as 2017.

But running out of money is not an option. In the end, some political calculation will be made, and it will have all the problems that collectivism breeds. Only from the starting point of individual freedom can effective solutions be found. But first, let's consider some of the politically motivated suggestions that have already been proposed.

Former President Bill Clinton succinctly laid out the limited options facing the country: raise taxes, cut benefits or invest privately. Let's consider the first two possibilities.

Raising or eliminating the cap on income subject to the 12.4% Social Security tax would mean the largest tax increase in U.S. history, trying to collect over $100 billion a year. This would hit upper-middle-class families and small business owners the hardest. Because entrepreneurs are the engines that stimulate economic and job growth, tax increases on them would be the most counterproductive, diminishing returns. Estimates suggest that over a million jobs would be lost and it would cost over $10 billion a year in lost economic growth.

Alternatively, we could double the tax rate and take 25% of every worker's paycheck. But Social Security is already the biggest tax that the average American family pays. With that rate on top of all the other taxes imposed, we might as well collect a worker's entire paycheck. The law of diminishing returns suggests that even these massive increases won't cover the shortfall.

All this toil to maintain an average benefit of about $12,000 a year!

The second option would be to cut benefits to Social Security recipients. The difficulty here is that Social Security has become elder welfare. Without it, 46.8% of Americans 65 and older would have incomes below the poverty line. Social Security lifts over 13 million seniors out of poverty.

It doesn't seem to matter that retired people aren't supposed to have income. It's evidently not relevant that some of those who would be below the poverty line are multimillionaires. You can have investments and real estate without having income. But any debate gets swamped by the image of the elderly forced to choose between purchases of food or their medications.

And it isn't as though the problem of elder welfare is not real. The average 65-year-old has less than $10,000 of investable assets. Once we were a nation of savers. Now we are a nation of debtors. And our policies encourage the borrow-and-spend crowd through constant bailouts and punish the save-and-invest crowd through constant tax increases.

The only reasonable way to cut benefits would be to eliminate them for retirees with a greater-than-average income. We already reduce benefits for higher incomes, and the effects are a social disaster. Many older people who would prefer to continue as productive members of society choose not to work or they do not work as much as they could, specifically to avoid a reduction in their benefits. These are not theoretical statistics. I know these retirees personally, and they choose not to work because their Social Security is slashed by 50 cents on the dollar, and then they still have to pay tax on top of that. Punishing the productive translates to less productivity.

Until Americans are willing to recognize that Social Security is a zero-sum game, they won't see that the system is hopelessly broken and no small fix will solve the fundamental flaw.

If Social Security had any real assets, they could be put to work growing and compounding over workers' productive years to provide for them during their retirement. But as a redistribution system, Social Security has no assets and therefore no growth. The system has to take money from some and give that money to others.

Currently, 3.3 workers pay taxes to support each retiree. The system has worked so long as the base of the pyramid was larger than the top. But the baby boomers did not have enough children, so when they retire, the ratio of workers to retired boomer will be only 1.8 to 1. Short of burdening the next generation with massive taxes to support us, there is no solution. The system was flawed from its inception.

There is no lock box. The current surplus purchases special-issue Treasury bonds. The money goes toward the government's general operating expenses, and what is left in the trust fund is the bond, a government IOU. Adding money to the trust fund simply increases the number of bonds, providing more money to be spent in the government's annual budget.

Thus Social Security is nothing but a pocketful of IOUs. All the IOUs claim they are paying a nice interest rate, but because the government holds the liability, this setup is only increasing the deficit, not earning real wealth. Government IOUs are a little strained these days, to say the least. They have been stretched even further by the $700 billion bailout plus the additional $100 billion of pork barrel spending that was tacked on to sugarcoat it enough for congressional approval.

The claim that free markets caused the nation's credit troubles are so ridiculous that only George Orwell's newspeak, the fictional language in his novel 1984, comes close to what we are hearing from politicians and the media. The vocabulary of newspeak gets smaller every year by removing any words or possible constructs that describe the concept of freedom. I'm afraid it isn't fiction anymore.

Those responsible for causing the current crisis pretend to be our saviors and gain unbalanced power as a result. The bill declares that financial institutions are "designated as financial agents of the Government." Then it goes on to state, "Decisions by the [Treasury] Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

Liberals and conservatives voters alike opposed writing the government a blank check because they long for freedom. Jim Moran, one of the most liberal members of Congress, was quoted as saying that calls to his office regarding the bailout were running about 50-50: "50% NO and 50% HELL NO!" The freedoms given up in the present bailout pale in comparison to those we will have to forgo when Social Security threatens to default.

What has become conventional wisdom in the current crisis is easily used as an argument against privatizing Social Security. But privatization is the only solution where the person who pays is also the person who benefits and also the person who controls how it is run. Only privatization provides the negative feedback within the system to regulate and dampen runaway reactions.

It is unlikely that Social Security will provide you a sufficient retirement lifestyle. But regardless of what happens in Washington, D.C., the most important actions to assure your own retirement are in your control. Be part of the credit solution. Make sure you are saving and investing at least 15% of your take-home pay.

from http://www.emarotta.com/article.php?ID=305

The Seven Steps of Financial Preparedness (2008-10-06)

The Seven Steps of Financial Preparedness

(2008-10-06) by David John Marotta

When a hurricane threatens, making a plan and gearing up for emergencies is imperative. Economic emergencies happen too, but it may be less obvious how to prepare. Here are seven steps you should take to weather any financial storm.

First, put $1,000 aside. It doesn't amount to a real emergency fund, but it will do until you get your finances in order. You can accumulate the $1,000 by allocating $10 a day for just over three months.

Most people go into debt because they live hand to mouth, spending 100% of their take-home pay. Then life happens: The car breaks down, the roof leaks or someone needs medical care. Without $1,000 in the bank, families spend the money anyway and go into debt. Having a mini-emergency fund can help you get out of debt and stay out of debt.

The second step to prepare for financial emergencies is to extricate yourself from credit card debt--forever. These first two steps are part of Dave Ramsey's financial peace course, offered in churches around the country. Ramsey suggests paying off your credit card by starting with the smallest balance in order to achieve small successes and then working to snowball your payments as you tackle the larger balances.

He also notes that the only way to get out of credit card debt is to adopt the intensity of a gazelle whose very life depends on outrunning the cheetah. If you are in debt, I highly recommend Ramsey's financial peace course. To be notified about the next course in your area, send your contact information to us at questions@emarotta.com.

These first two steps, having $1,000 and paying off debt, simply prevent you from facing a financial emergency by starting out wounded and bleeding. The third step is to improve your ability to handle fluctuating monthly expenses.

Set up a monthly budget so your day-to-day expenses are less than 65% of your take-home pay. No matter what your income, living off a smaller percentage of what you earn is the way to grow rich and be better prepared for financial emergencies. The difference between those growing rich and those remaining poor is not the salary they make. It is the salary they keep.

Relative to their income, the rich are frugal. They save and invest. They spend less than 65% of their take-home pay on day-to-day expenses. They save at least 10% in their retirement accounts and another 5% in taxable savings. They direct another 10% toward unknown big purchases. And they even live frugally enough to give another generous 10% to charities.

Setting aside 35% for unanticipated expenses is the minimum. When my wife and I first started our life together, we did not make very much. But we still lived off about half of our take-home pay. We were fresh out of college and did not have a very high lifestyle. After starting a family it becomes much more difficult, but not impossible, to save money. Remember that even if you don't earn very much, probably a family somewhere is living on half of what you make and doing just fine.

If you are well off, you can set your sights even higher. Think of learning to live frugally and still be content as part of the emotional training you need to weather a financial storm. That training starts with living within a budget even when financial conditions are good. Some productive families live off less than 15% of their take-home pay and still save, invest or donate generously with the other 85%.

Frugality is a skill needed to live a good life. It is a mindset best learned from parents, but even if yours were spendthrifts you can reeducate yourself and learn to view money differently. The poor buy things; their homes are cluttered with them. The middle class buys liabilities on which they have to make payments, such as second homes, luxury cars and boats. The rich buy investments that pay them money.

If you want to break your poor or middle-class mindset and learn how to be frugal, help is available. In addition to Ramsey's course, I recommend Dana Adams's blog "Frugal in Virginia" (www.frugalinvirginia.com), which describes where to find deals, both locally and on the Internet, that will stretch your family's budget. Not only will these suggestions save you money, but the mindset of frugality is contagious and will help you overcome any bad habits you may have learned growing up.

Once you've set your budget so money is left over after paying the bills each month, in step 4 you automate your cash flow to promote saving and investing.

Every month, have 10% transferred into your retirement account before you receive your paycheck. Then automate the transfer of 25% of your take-home pay into an investment account a day or two after your paycheck is deposited. Automating your savings makes savings a high priority and ensures that you pay yourself first. This investment account will grow over time, and you can use it to pay for big emergencies and charitable gifts.

Keep the balance in your checking account between two and three times your monthly expenses. If you are paid monthly, your bank account should cover two months of expenses the day before you are paid and three months the day after. You'll have both a generous cushion for your checking and money for unexpected repairs or big purchases. Whenever your checking account exceeds three months of take-home pay, consider moving some of it into a higher paying investment.

You need an emergency fund in case you are unemployed. The first three months of the fund are safe in your checking account. Now invest an additional three months in vehicles you could easily sell within 90 days. Your emergency fund investments should not be in a retirement account, but they do not need to be in a money market account. Many people use no-load, no-transaction-fee mutual funds. They should also be stable enough to guarantee three months' worth of expenses. Therefore if your emergency reserve funds are large enough, you can diversify them fully into investments that fluctuate more but pay a higher rate of return.

Step 5 is creating an asset allocation for your investments that's diversified for safety while being invested for appreciation. Diversification works, and it's never more obvious than in times of market turmoil.

Without diversification, portfolios can have a zero return over a decade. After being well diversified, the likelihood of no return over a decade drops significantly. Your asset allocation should be a guideline in times of trouble. Whenever you are worried or glad about what is happening in the markets, rebalance your portfolio back to your target asset allocation.

Rebalancing means buying stocks after they have gone down and selling stocks after they have gone up. This contrarian move is always wise. When stocks are hitting new highs, rebalance. When stocks are making new lows, rebalance. Studies suggest that the simple act of rebalancing annually earns about a percentage and a half more.

The sixth step toward emergency preparedness is using your taxable investment account properly. You are putting in 25% of your take-home pay each month: 5% is taxable savings and should start to accumulate real wealth, and 10% is for charitable gifting. Each month you buy investments, some will grow in value and become highly appreciated. Each year, find the investments that have appreciated the most, and use these for your charitable contributions.

Done properly, this method of annual charitable gifting plants the seeds for gifts that may not be realized until ten years later. Thus your charity can survive for ten years after you have stopped contributing on the front end.

The last 10% is for unknown large purchases. If your first response to this suggestion is to ask, "Like what?" the answer is "Exactly." Most people who run up credit card debit keep their regular spending within 100% of their take-home pay until some unexpected expense causes them to deficit spend. You can't anticipate unknown unknowns, so the best you can do is set aside some money to cover them when they arise.

Having the discipline to budget for small financial emergencies will help you be prepared when you encounter larger financial crises. When some unknown spending need strikes, take the money to cover the expense from your growing emergency fund. Then, determine if you have been budgeting for this level of unknown expenses adequately.

You should be able to budget for car repairs, medical bills and house repairs. If the expense truly swamps what you have been saving, you may need to increase the amount to better anticipate the level of emergencies.

The seventh and final step is mobilizing during an actual emergency.

In a real financial emergency you should have two to three months of spending in your checking account and another three months in your taxable savings. You should have a pile of money for large unknown purchases (that 10% of your pay) and another pile of taxable savings (that 5% of your pay you have never touched). Finally, you should have been planting seeds toward future charitable gifting that will last through the next decade.

Usually emergencies don't happen. So the money you have socked away makes more money. Keep an emergency fund for several years and it should double in value, giving you an additional emergency fund. Whether you need it or not, being prepared for a financial emergency means peace of mind, knowing that your lifestyle is sufficiently frugal so you won't be in trouble.

from http://www.emarotta.com/article.php?ID=304

Our Financial Crisis: The Result of Centralized Planning (2008-09-29)

Our Financial Crisis: The Result of Centralized Planning

(2008-09-29) by David John Marotta

Assigning blame for recent events in the financial markets is today's most pressing political issue. Unintended cause and effect are both complex and subtle, but recognizing the culprits is important if we want to avoid giving them additional power and responsibility.

Two different opinions are circulating to explain the fundamental cause of our failed financial markets. One claims that unfettered capitalism and greed caused excessive risk taking, which harms society. This argument maintains that without constraints capitalism produces grand profits during market increases, but the losses are socialized by government bailouts in times of trouble.

The other opinion holds that regulation and centralized planning have caused financial instability and failing institutions. If this is the root cause, then many of the proposed solutions will only make matters worse.

The pending election politicizes the issue and impedes clear thinking. But clear thinking is paramount. One of these two opinions is closer to the truth, and economic public policy must be based on truth, not emotion. The forensic evidence points to centralized planning. Let's look at whose fingerprints were left behind.

The failed institutions were among the most highly regulated industries in the country. If the subprime meltdown was the result of greedy capitalists, you would have to assume they were awfully inept to have lost so much money. The markets are smarter than that. Only feel-good legislation could be so naive.

Bill Clinton's presidential website still boasts of creating the highest homeownership rate on record. In 1994, Clinton hoped to increase homeownership to 67.5% by 2000. He sponsored the revised Community Reinvestment Act (CRA) regulations, which required banks to increase mortgage lending to low- and moderate-income families. These changes also allowed the securitization of CRA loans for subprime mortgages.

The revised act resulted in a raft of community organizers who could now prevent banks from merging, expanding their branches or creating new branches simply by protesting to any of four different regulatory agencies. Using regulation as a weapon, community organizers could now bully and blackmail private businesses. Legislation that encourages such thuggery produces anything but free markets.

These community groups described the regulatory pressure forcing banks to increase their underwriting of low-income loans as positive and encouraging. Bruce Marks of the Neighborhood Assistance Corporation of America boasted to the New York Times that he had netted $3.8 billion in loan commitments in the city of Boston alone.

Banks were scored on their results rather than the fairness of their process. Those that scored poorly were punished. Most banks complied. As a whole the industry increased its lending to low-income families by 80%, more than twice any other group. Advertisements said that CRA loans were available with "100 percent financing . . . no credit scores . . . undocumented income . . . even if you don't report it on your tax returns." Mere participation in a credit counseling program qualified as proof that the applicant was capable of managing the debt.

The government-sponsored entities Fannie Mae (the Federal National Mortgage Corporation) and Freddie Mac (the Federal Home Loan Mortgage Corporation) were involved as well. Because of their government backing, their bonds have the highest possible credit rating (A1). Only their guarantee was considered as secure as federally issued bonds. This implied backing allowed them to sell their loans at a lower yield than any private firm could muster.

Although Fannie and Freddie were officially created to encourage the development of private markets, they thwarted every attempt to take their influence away. They are powerfully connected, and following their lobbying efforts and campaign contributions leads directly to the politicians responsible for encouraging and continuing regulatory interference.

These agencies became places where former government officials went to enrich themselves and wait for new federal appointments. Their chief executives had contract clauses providing severance benefits when they left for a government post. While homeowners took cash out of their homes, politicians treated themselves by using Fannie and Freddie as political ATMs.

As a result, Fannie and Freddie became two of the largest corporations in the world, with about 80% of conventional home loans. Their monopoly on the housing market is anything but a free market.

Because they are government sponsored, these two entities were expected to engage in public policy as well. They were enthusiastic supporters of the CRA. They even singled out Countrywide as one of the lenders with "the most flexible underwriting criteria permitted."

Countrywide's low-income loans grew from a $1 billion commitment in 1992 to $80 billion by 1999 and $600 billion by early 2003. It was one of the first companies brought down by the current pressures and sold to Bank of America.

Fannie and Freddie were encouraged by their federal overseers. The Office of Federal Housing Enterprise Oversight (OFHEO) was charged in 1992 with keeping tabs on their financial safety and soundness, and the U.S. Department of Housing and Urban Development (HUD) was supposed to manage their housing mission.

The dangers of Fannie and Freddie failure were widely known and discussed publicly before the establishment of OFHEO and HUD's oversight. The regulatory oversight was specifically implemented to avoid complacency and ensure that their social mission would not jeopardize their financial soundness. Oversight obviously did not work.

HUD's mandate was implemented by requiring a certain percentage of the mortgages purchased by Fannie and Freddie to support low-income families. HUD's purchase quotas of low-income loans rose sharply over the past 15 years. Given their implied guarantee against failure, this increase was not perceived as reckless for Fannie Mae bondholders, but it has proven disastrous for nearly everyone else involved.

It isn't as though oversight failed because the issues were not known. In 1991, Carl Horowitz of the Heritage Foundation warned about H.R. 2900, the bill to create OFHEO and HUD oversight. And a 1999 New York Times story stated, "In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's."

The plethora of federal entities that regulated and oversaw all of the failed firms gave us a false sense of security. In retrospect, the cause and effect seems obvious, but none of the agencies already involved took the steps they could have. Believing government bureaucrats are wiser than the free markets is a socialist utopian delusion.

As recently as 2003 the Bush administration was pushing Congress to overhaul Fannie and Freddie and require stricter lending practices. Barney Frank, chairman of the House Financial Services Committee, who is supposed to provide oversight, said, "These two entities--Fannie Mae and Freddie Mac--are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." So much for congressional oversight.

The government itself created the conditions of greed and lack of negative feedback. Free markets use negative feedback instead of regulations and legal constraints. But when the federal government legislatively removes the negative feedback, which is the natural consequence of poor decisions, it makes such decisions more likely and causes more harm than good.

Planning for competition works wonders. Planning substituted for competition wreaks destruction.

Given that socialistic impulses got us into this mess, it isn't likely that further socialization will help matters in the long run.

Now the government is loaning AIG $85 billion, but at what cost? Virtually nationalizing the country's largest insurance company was not the only possible solution. Providing AIG with a loan to allow the company time to sell assets would have been much less intrusive. Instead, the government provided additional bond security at the expense of shareholders' value.

None of this intervention would be the free market solution, and it is all rife for political manipulation. Only by getting government out of the private markets can we reduce corruption.

Popular opinion overwhelmingly supports free markets. According to a Rasmussen survey, only 7% of voters think the federal government should use taxpayer funds to keep a large financial institution solvent. Sixty-five percent favor letting the company file for bankruptcy. And 49% said they worried the federal government would do too much to purportedly solve the financial crisis.

Any kind of bailouts and interventions encourage excessive risk taking in the future. When people gamble with others' money, they take bigger risks. We should be skeptical that financial institutions that made bad investments can somehow infect well-run banks. In fact, letting poorly managed banks go under is good for those still standing. Financial institutions have needed a pending consolidation, and allowing such failures should make the remaining financial services industry more profitable going forward.

Fannie Mae and Freddie Mac should be dissolved, and a more stable diversified collection of private companies should replace them. Any time power is consolidated in the hands of a single government entity with centralized decision making, the resulting structure has a great propensity for harm.

Such concentrated power is infinitely heightened. It can be used monopolistically and has no competitive negative feedback. With multiple private entities, there is naturally less power to be abused or mistaken. There is no way a diversified collection of private companies could have failed so spectacularly.

It requires a savvy voter to understand the root causes of these financial troubles during a time of political blame shifting. But even the average citizen should be skeptical that bigger government and additional regulation will somehow put more money in middle-class pockets. That we are largely left without politicians who endorse these views is most unfortunate.

from http://www.emarotta.com/article.php?ID=303