3. Unanimously Agreeable Rationale of Governance
4. Federal Mortgage Insurance Corporation is Financially Suicidal for Taxpayers
5. War to Take Control Over Mortgage Market

These are three chapters of "Coalition of Borrowers,
Government-Regulated Lender, Interest Rate and Safe Central Bank in Equilibrium"

Note: I own a few shares of Fannie Mae now. I did not hold any company's stock in 1991, however, when I found through research, mimeographed at the Federal Reserve Board, Washington, D.C., that the federal guarantee of bank debt was inefficient and unstable for the system of money and finance. I have found now a similar conclusion about FMIC, as presented in the paper on coalition of borrowers. This taxpayer or public guarantee of bank debt is the root cause of moral hazard, instability and inefficiency of the system of money and finance, which also transgresses the constitutional tenet of fundamental fairness.

3. Unanimously Agreeable Rationale of Governance

The prevailing rationale of governance assumes that individuals maximize the utilities of their wealth or consumption.  This rationale has inextricably bonded the vast majority of households, their employers and governments with an estimated $100 trillion of debt worldwide.  The gargantuan debt burden is the crux of the current global economic crisis.  The vast majority of indentured borrowers cannot accept the prevailing rationale of governance that has caused their bondage. 

No one including usurpers (robbers) will like to be usurped (robbed), even surreptitiously.  This universal fact makes governance that precludes usurpation unanimously agreeable.  This memo illustrates how the U.S. can use the unanimously agreeable rationale of governance to set policy for the two home financing entities, Fannie Mae and Freddie Mac.

Foundation of the Prevailing Rationale of Governance:  Robert Lucas won Nobel memorial prize in economics for rationalizing arguments-of Nobel colleagues Milton Friedman and Edmund Phelps and John Muth-that monetary stimulus (printing or borrowing new money and/or cutting interest rate on savings) raises future inflation while boosting employment only in short run, not long run.[1]  Governments and central banks have followed this rationalization to inject frequent monetary stimuli to boost employment in short runs.  This is how the staggering amount of debt has been created worldwide.  The rationale underlying frequent short run monetary stimuli is Ken Arrow’s Nobel memorial prize winning theory that individuals make choices by maximizing the utility of their wealth or consumption. 

The unanimously agreeable rationale of governance stated above is necessary to resolve an apparently abstruse policy on Fannie and Freddie.  Contrast the opposite preferences of creditors and debtors: 

  1. Creditors want to shut down Fannie and Freddie.  If Fannie and Freddie are shut down, private banks will face less competition in home mortgage financing.  Less competition means higher return on creditors’ investments in mortgages made through private banks.  With Fannie and Freddie eliminated, private banks will have larger home mortgage portfolios than that they currently have.  Private hedge funds jointly owned by creditors and private bank executives can then use the larger home mortgage loan portfolios for greater leverage in trading to usurp others’ wealth. Fannie and Freddie charters do not allow such private hedge funds for creditors.
  2. Borrowers and the home building industry want continuance of Fannie and Freddie for as low an interest rate as possible to home mortgage borrowers in completion with private banks. 

Creditors and borrowers arrive at diametrically opposite choices based on maximization of utilities of their wealth or consumption.  The government cannot, therefore, use the prevailing rationale of maximization of utilities of individuals to set a policy for Fannie and Freddie.  The vast majority of borrowers will not accept the prevailing rationale for governance which has inextricably bonded them.   

So, how should the government decide whether to continue or wind down Fannie and Freddie?  Research shows that Fannie and Freddie-as private shareholder-owned entities, regulated like private banks-are necessary to attain equilibrium (stability), efficiency and fundamental fairness in the economy.  This equilibrium is remarkably consistent with the unanimously agreeable rationale of governance for the following reasons: 

  1. As shareholder-owned entities, Fannie and Freddie have the incentive to charge sufficiently higher mortgage interest rates than the cost of their funds and operation including salaries and benefits of their staff.
  2. In equilibrium, private banks are allowed to compete with Fannie and Freddie to earn the same level of profits (or better if they operate more efficiently) on their equity investment in mortgage lending business. This allows creditors to earn at least the same rate of return on their mortgage investment at private banks as they can earn from such investment in Fannie and Freddie. 
  3. The equilibrium allows private banks to earn at least the same level of compensation for their executives as Fannie and Freddie offer to their staff to generate their profits.
  4. In equilibrium, shareholders of Fannie and Freddie are required to hold as much capital as private banks and absorb the first-risk, as residual claimants, before the government steps in to protect guaranteed debt holders. 
  5. Directly or indirectly, private banks lend their allied hedge funds that trade to usurp others’ wealth, surreptitiously.  The unanimously agreeable rationale precludes guarantee of such private bank debt.  Fannie and Freddie charters do not permit lending to private hedge funds.  The unanimously agreeable rationale cannot, therefore, preclude government guarantee of their debts.  

The extant punditry for winding down Fannie and Freddie is not logically founded in the prevailing rationale of governance.  Such punditry is also inconsistent with the unanimously agreeable rationale of governance, presented here.  The unanimously agreeable rationale of governance is constitutional, stable and efficient.  The prevailing punditry to wind down Fannie and Freddie is unconstitutional, inefficient and unstable. 

4. Federal Mortgage Insurance Corporation is financially suicidal for taxpayers.

Senators Tim Johnson and Mike Crapo have revived the Corker-Warner bill (a) to transfer all Fannie and Freddie mortgage assets to private banks at unstated prices and (b) to create a Federal Mortgage Insurance Corporation (FMIC) to offer taxpayer guarantee at unstated insurance premiums for the second 90% loss on mortgage loans issued and held by private banks. 
This bill presumes no moral hazard in the banking and finance industry.  It also presumes ability of regulators to monitor risk and determine fairly (a) the unstated prices of current Fannie-Freddie mortgage assets at which these assets are slated to be sold to private banks, and (b) the unstated mortgage insurance premiums to be paid by private banks.

In other words, the Johnson-Crapo-Corker-Warner bill presumes that the 2008 financial catastrophe did not occur and that such a catastrophe would never occur.  In fact, this bill is consistent with the declaration of the president of American Economic Association in 2003 that the finance industry was invincible, i.e., immune to risk of Great Depression.  In the same year, I had warned the Congress about a looming financial crisis due to moral hazard.  I had then proposed (i) a safe central banking policy and (ii) a consolidated bank capital requirement for bank holding companies to preemptively avert the crisis.  The Congress adopted these policies in 2008, only after taxpayers lost trillions of dollars, millions of jobs were wiped out and many families ignominiously lost their homes. 

Rampant moral hazard in the finance industry is the root cause of the economically debilitating financial crisis of 2008.  Moral hazard is due to federally insured mega bank executives owning private hedge funds for them and allied wealthy and powerful creditors.  The wealth and power stem from transfer of wealth from the rest of society through highly leveraged trading shenanigans based on federally insured cheap deposits and information garnered from order flows at market making subsidiaries.  Even the U.K. Prime Minister, Gordon Brown, has admitted in a column in Washington Post in October 2008 that the financial crisis was due to undisclosed and irresponsible lending.   One of my papers argues how lending federally insured funds to private hedge funds is financially suicidal to taxpayers

The FMIC will raise the moral hazard risk facing taxpayers to a gargantuan level.  For example, a private bank issues pure toxic (liar) loans, gets the loan pool rated AAA by bribing rating agencies and then insures it by the FMIC for the bottom 90% of losses for, say, at most 10% of par value of the loans.  The loans default 100%.  The FMIC pays the bank 90% for the default coverage, ex post, while the private bank pays FMIC for insurance of10% of loan value.  The private bank makes 80% of the par value of loans from taxpayers by taking no risk and by making no real loan.  The idea of FMIC underlying Johnson-Crapo-Corker-Warner Bill is, thus, financially suicidal for taxpayers.  If Fannie and Freddie operate as private-shareholder owned government-regulated lenders, they will not purchase such liar loans and will promptly sue private banks for selling such loans.  FDIC has rarely, if at all, sued mega private banks.  FMIC will also act like the FDIC as an agent, not regulator, of private banks.  Fannie and Freddie have not hesitated in suing private banks to collect hefty settlements for mortgage fraud.

If the idea of the senators is to let the private banks and other creditors benefit from the current profits of Fannie and Freddie due to mortgage lending, they should have FHFA allow every investor including banks to purchase Fannie-Freddie mortgage backed securities.  This freedom for investment in Fannie and Freddie securities indeed existed before the GSEs were taken over by the government through conservatorship.  Resumption of this freedom to invest in Fannie and Freddie securities will allow banks, creditors and investors to have a skin in the game to gain the enormous profits accruing to Fannie and Freddie due to their efficiency in risk pooling.  This necessitates scrapping of conservatorship and counting all payments (so-called dividends) made by Fannie and Freddie as repayment of loans made by the Treasury to the GSEs.

Fannie and Freddie were brought under conservatorship basically to buy the toxic private bank loans using taxpayer funds passed through Fannie and Freddie.  Most of the $188 billion lent by the US Treasury to Fannie and Freddie and the internal cash reserves of the two firms written down by government decree were indeed given away by taxpayers, borrowers and shareholders to private banks during the 2008 crisis.  Such give away vitiates the Uniformly Agreeable Rationale of Governance.

The private banks now want to purchase the good mortgage loans held by Fannie and Freddie at throw-away prices after passage of the Johnson-Crapo-Corker-Warner Bill.  This will amount to a transfer of wealth from taxpayers, Fannie-Freddie shareholders and borrowers to private hedge funds via private banks.  Why should taxpayers, borrowers and Fannie-Freddie shareholders agree to such transfer of wealth to private hedge funds, owned and controlled by privileged mega banking executives and associated creditors?  This bill is another scheme to privatize gains and socialize losses.

The argument that private banks do not have a level playing field to compete with Fannie and Freddie on issuance of mortgage loans is specious for the following reasons:

  • Privileged private banking executives and allied creditors own and operate private hedge funds to reap enormous profits by leveraging cheap federally insured funds at their disposal and information from trade flows in their market making subsidiaries. Such privileged wealth transfer causes massive destruction of capital, i.e., accumulated value of labor of people who persevere to produce, create and serve to prop national security and currency.   
  • These privileged private hedge funds are not open to the vast majority of unprivileged investors.  The profits of these funds are not shared with home mortgage borrowers.  Very little of these profits, if at all, come as taxes to the public exchequer.  In fact, the capital destruction caused by trading shenanigans of privileged hedge funds leads to unemployment and severe underemployment causing substantial decline in collection of taxs.
  • Privileged private banking executives and their creditors can invest in Fannie and Freddie securities to earn a share of profits coming from basically a higher interest rate on mortgages levied on borrowers than the cost of funds to Fannie and Freddie.
  • Fannie and Freddie do not operate private hedge funds for anyone.

The only purpose of the Johnson-Crapo-Corker-Warner Bill (dismantling Fannie and Freddie and creating FMIC) that one can infer rationally is to rip off taxpayers, borrowers and current Fannie and Freddie security holders for further aggrandizement of privileged private hedge fund owners.  All the new lending standards in the bill can be adopted by Fannie Mae and Freddie Mac so that borrowers have no subsidy, according to my no-subsidy mantra of governance to attain the most efficiently competitive economy.

This paper forms the basis of all crucial historical struggles faced by mankind, starting with Saint Vashistha proposing zero interest rate on fiat money in 500 B.C.  Saint Vashistha is described as an Indian Lawmaker in British literature.  He undoubtedly was the first recorded monetary economist.  Philosophers Aristotle and Plato also sought zero interest rate on fiat money.  Prophet Mohammed enunciated a new religion to establish a riba-free (interest rate free) system in 600 A.D.  The Bible too adopted this philosophy in 1700 A.D.

For the first time, however, we now have a rigorous proof within a general equilibrium model of modern economics that the interest rate should be zero, that fiat money should not be artificially created and that a safe central bank be established for stability, efficiency and fundamental fairness. 

One can now see how the epic war since time immemorial is being waged by those who have established a privileged system to create fiat money artificially and to usurp the same disproportionately and use their power of their credits so accumulated to further usurp the hard-earned savings of the vast majority that perseveres to produce, create and serve to prop national security and currency. The privileged creditors want to levy an unsustainable interest rate on the others forced to borrow that money and perpetuate the system of robbery to never diminish their accumulated credits and power.

Incidentally, may I state that I did not hold any company's stock in 1991, when I found through research mimeographed at the Federal Reserve that the federal guarantee of bank debt was inefficient and unstable for the system of money and finance. I have now found a similar conclusion about the idea of FMIC presented here. This taxpayer/public guarantee is the root cause of moral hazard, instability and inefficiency of the system of money and finance, which also transgresses the constitutional tenet of fundamental fairness (Acharya, 2013).

5. War to Take Control of Home Mortgage

The revival of a defunct (Corker-Warner) bill which was tabled away a year ago shows that a mortgage war has erupted for taking control over about $8 trillion of home mortgage assets (loans) now held by Fannie and Freddie.  These assets currently generate about $50 billion of annual profits, despite relatively moderate interest rates charged by the two government-sponsored enterprises. These profits represent the difference between the mortgage interest rate paid by borrowers and the cost of funds and operations of Fannie and Freddie.  The profits are, thus, transfers from mortgage borrowers to Fannie and Freddie and then to Treasury through the profit sweep agreement signed in August 2012.  The profits on the same mortgage loans would rise astronomically if they were held by private banks that need to charge much higher interest rates to cover massive executive compensations. 
The true opponents in the erupted mortgage war are as follows:

  • Privileged creditors that own private hedge funds, which are co-owned and controlled by top executives of mega bank holding companies (BHCs) who are members of the Clearing House LLC and who are protected by the Federal Reserve Act of 1913.  The FRA ordains that the Federal Reserve print new money for any privileged BHC before the latter becomes insolvent.  By the FRA, no privileged BHC ever becomes insolvent.  It seems obvious that privileged creditors include many lawmakers, as per sketchy news reports.   
  • Unprivileged vast majority comprising (i) home mortgage borrowers, (ii) household investors, (iii) mutual funds, (iv) pension plans, (v) businesses, (vi) smaller banks and (vii) millionaire and billionaire hedge funds.

The Unprivileged vast majority will be crushed and the privileged few will become enormously richer and more powerful by the Corker-Warner-Crapo-Johnson Bill.  How?

  • The Bill basically ordains that the government of We the People give away Fannie-Freddie mortgage loans to the privileged creditors and their private banks at prices unstated in the Bill. 
  • Fannie and Freddie have purchased these mortgage loans by paying hefty premiums and fees to private banks to generate enormous profits for the latter.
  • Fannie and Freddie wrote off the toxic loans purchased mostly from privileged private banks and settled mortgage fraud cases after they were taken over by the government via conservatorship.  They now have cleaned their books.  Most of their current loans are creditworthy, generating hefty profits. 
  • The Bill ordains the mega privileged banks as de jure Biggest Shorts ever created by mankind: after selling mortgage loans for enormous profits, these Shorts can buy back the good Fannie and Freddie mortgage loans at heavy discounts to gain net upfront windfall profits and a perpetual stream of annual income of at least $50 billion per year from home mortgage holders.  The present value of a perpetual stream of annual incomes of $50 billion is $50 billion divided by .04 (cost of capital), equal to $1250 billion.  The cost of capital is actually much less than 4% taken here to get a low-ball estimate of the present value of the income stream. 
  • The Bill thus gives away an unseemly upfront profit due to unstated (hush-hush) discount on the $8 trillion of Fannie and Freddie mortgage loan portfolio and a present value of $1250 billion to the privileged few. This give away is fundamentally unfair and unconstitutional.  It is going to exacerbate inequality to a far greater degree than the pre-Great Depression era inequality already reached in the economy.  The Bill is a recipe for instability and inefficiency.
  • The Bill deprives all the unprivileged investors of the opportunity to invest in Fannie and Freddie securities like bonds and notes for interest income and common and preferred stocks for dividends.
  • The unprivileged home mortgage borrowers will pay a hefty price due to exorbitantly high mortgage interest rates and fees set by the privileged creditors and banks if the Bill passes. 
  • This Bill is a script for legalizing usury, which is currently illegal
  • Every aspect of the Bill which is crucial and material is unstated: price at which Fannie and Freddie loans will be given away to privileged private banks, the mortgage insurance premium to be levied by the FMIC and, more importantly, any regulatory rule needed to avert future financial calamity due to moral hazard. 
  • To not legalize usury and to avert another financial calamity, the Corker-Warner-Johnson-Crapo Bill has to be completely abandoned, safe central banking has to be adopted and Fannie and Freddie should be released from conservatorship as private shareholder owned entities with their debts guaranteed by the government.  Releasing Fannie and Freddie, cancelling the profit sweep agreement with Treasury, and relisting their stocks in NYSE will (a) allow every investor (including the currently privileged) to invest in their bonds, preferred stock and common stock, and (b) let the Federal Reserve sell off its agency debt holdings to all investors, and (c) restore much-needed confidence of investors that the government will not confiscate their assets irrationally at the behest of the few privileged.  
  • The vast majority of ordinary unprivileged Americans with no financial investments and no bank accounts and their political representatives now falsely presume that they are unaffected by unprivileged investors losing in the system of legalized robbery established by the privileged. But this majority bears the heaviest cost of all due to a loss of their incomes, jobs and homes when the unprivileged investors respond to their losses by winding down businesses, cutting pays of workers and firing employees. The economy then nosedives.  The government then collects less tax from a shrunk pool of taxpaying households and businesses.  The government or the central bank then prints money to meet its obligations. The cost of living then rises.  It hurts the taciturn majority and their representatives the most.

All unprivileged Americans thus need to wake up to see the truth:

  • Fannie and Freddie did not cause the 2008 crisis, as played out by media controlled by the privileged. 
  • The truth is that privileged private banks lowered their lending standards to create a lot of toxic and fictitious mortgage loans to sell them to Fannie and Freddie at hefty premium and fees, before the 2008 crisis.
  • When Fannie and Freddie refused to buy the undocumented toxic loans, the privileged private banks pressured the then US Treasury to take over Fannie and Freddie under conservatorship.  Fannie and Freddie were then forced to buy these toxic and fictitious loans.
  • Private banks rarely sell their good loans to Fannie and Freddie.  The privileged private banks have admitted their mortgage fraud by paying large fines to Fannie, Freddie and Treasury.  After writing off those forcefully dumped toxic loans, Fannie and Freddie are enormously profitable.  This proves that Fannie and Freddie would not have taken any assistance from the US Treasury if they were not forced to purchase toxic and fictitious mortgage assets from private banks. 
  • The financial catastrophe of 2008 was, thus, caused by reckless lending by private banks and their creditors.  The privileged accumulated their credits mostly by usurping from the unprivileged majority through the established system of legalized robbery. 
  • Now that Fannie and Freddie have cleaned their books to generate huge profits, the same few privileged private banks and creditors that caused havoc for the unprivileged are compelling the Congress to take over the good Fannie and Freddie loans at hefty discount and an income stream currently valued at least $1.250 trillion by paying no price.  It is inefficient, unstable and fundamentally/constitutionally unfair to grant such unseemly gargantuan reward to a privileged few, who ruined the unprivileged in 2008 and are hell-bent to ruin any fair opportunity available to the unprivileged vast majority that ironically generates all the products and services necessary for the privileged to survive.   
  • The economy is guaranteed to crash sooner, rather than later, if Fannie and Freddie are dismantled by doling out their valuable mortgage assets to a few privileged creditors. The unemployment and underemployment rolls will swell. 
  • This Bill should be a wakeup call for all unprivileged Americans and their representatives in the government, even if they have no financial investments or bank deposits.

[1] The Phillips curve (plot of employment against inflation) is sloping upwards in the short run, but is vertical in the long run.  http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1995/press.html