Germany Launched a Propaganda Campaign (‘Gold for the Fatherland!’) to Persuade Citizens to Exchange Gold for Paper

Paper currency — fiat money, it has often been called — now rapidly became the only currency in circulation. Gold coins, from now on, were either hoarded by individuals, therefore being removed from circulation, or became the property of the government, which was from the start keen to persuade an often reluctant populace to hand over whatever gold it still had, whether in the form of money or valuables. Gold represented, to the German government, something they could trade internationally, for precious militarily important minerals and products that had to be purchased abroad. Most important of all, under the Loan Bureau Law (Darlehenskassengesetz) that had also been included among the 4 August measures, the more gold the government had in its vaults, the more paper money it could issue while still maintaining the all-important appearance of a gold-backed currency.

The problem was that, although the Reichsbank knew that 5 billion gold marks were in circulation at the outbreak of war, even by the end of 1914, after several months of an intensive propaganda campaign to persuade citizens to exchange gold for paper (‘gold for the Fatherland!’), it held only 2 billion of that total. Although all over the country patriots had obediently given up their gold and silver coins, many other Germans — especially in rural areas — proved immune to patriotic blandishments. They held on to the value they knew they could rely on, whatever the outcome of the developing European catastrophe. Somewhere, a lot of gold and silver was being hoarded.

—Frederick Taylor, The Downfall of Money: Germany’s Hyperinflation and the Destruction of the Middle Class (London: Bloomsbury Publishing, 2013), e-book.

Around 163 Million Gold Marks Were Redeemed from German Banks and Stuffed under the Nation’s Collective Mattress

Despite attempts by the government-guided press to convince them of the solidity of the everyday currency, many Germans suddenly didn’t trust paper any more. They wanted the security of the gold that the currency was alleged to represent. In the first weeks of July, around 163 million gold marks were redeemed from German banks and stuffed under the nation’s collective mattress.

On Friday 31 July 1914, the doors of the Reichsbank were closed (private banks had already stopped exchanging currency for gold three days earlier) and they did not reopen until the following Tuesday — by which time there was no point in demanding gold for your paper money, because the bank would not give you any. On 4 August a raft of emergency currency and financial laws formally declared the convertibility on demand of paper money to gold suspended for the duration of the conflict. It was at this point, actually, that the term ‘gold mark’ came into usage, referring to the actual gold coin worth, by metal weight, either five, ten or twenty marks. There were also one-, two-, three- and five-mark coins struck from 900/1000 silver, and their convertibility was suspended as well. After all, until then all notes had been convertible, merely representing a gold value, so there were only ‘marks’.

—Frederick Taylor, The Downfall of Money: Germany’s Hyperinflation and the Destruction of the Middle Class (London: Bloomsbury Publishing, 2013), e-book.

“The Catastrophic Depreciation of Our Currency,” Wrote Mises in 1919, “Must Be Accepted As Our Inescapable Fate”

The catastrophic depreciation of our currency must be accepted as our inescapable fate. Imperialist and militarist policies are inevitably linked with inflationism. A consistent implementation of socialization necessarily leads to the total collapse of the monetary system. This fact is corroborated not only by the history of the French Revolution but by what is happening in Russia under Bolshevism and in a series of other countries that have more or less closely followed the Russian example, but where less bloody methods have replaced the appalling brutality of the Jacobins and the Bolsheviks. No matter how disastrous a collapse may be, it does at least have a salutary effect in that it annihilates the system that brought it into being. The collapse of the assignats dealt a deathblow to the policies of the Jacobins. After the collapse, new policies were pursued. In our case, too, the collapse of the currency will give us a fresh start in our economic policy. . . . 

Moreover, the psychological significance of a complete depreciation of the crown on foreign-exchange markets should not be underestimated. The crown has already lost a lot of ground in the wholesale and real-estate markets, and it is becoming more and more common to buy and sell with foreign currencies, even in the retail market. As the value of the crown falls close to zero in foreign-exchange markets, this tendency will become all the more pronounced and will assume catastrophic proportions as soon as the crown becomes valueless in Zurich and Amsterdam. It is obvious that it will become impossible to sell imported commodities in crowns. As soon as the “black marketers”—on whom the urban population in German-Austria is entirely dependent for its food supply—refuse to accept crowns, they will be completely displaced from the domestic markets. Crowns will still be accepted for taxes, for the payment of rent, and for rationed food supplies, but they will no longer be usable on the unregulated markets.

—Ludwig von Mises, “On the Actions to Be Taken in the Face of Progressive Currency Depreciation,” in Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression, ed. Richard M. Ebeling, vol. 2 of Selected Writings of Ludwig von Mises (Indianapolis: Liberty Fund, 2002), 49-50.

The Public Begins a “Flight from Money,” Invests in ANY Real Goods, and Lowers the Demand for Money to Hold to Zero

The lower demand for money allows fewer resources to be extracted by the government, but the government can still obtain resources so long as the market continues to use the money. The accelerated price rise will, in fact, lead to complaints of a “scarcity of money” and stimulate the government to greater efforts of inflation, thereby causing even more accelerated price increases. This process will not continue long, however. As the rise in prices continues, the public begins a “flight from money,” getting rid of money as soon as possible in order to invest in real goods—almost any real goods—as a store of value for the future. This mad scramble away from money, lowering the demand for money to hold practically to zero, causes prices to rise upward in astronomical proportions. The value of the monetary unit falls practically to zero. The devastation and havoc that the runaway boom causes among the populace is enormous. The relatively fixed-income groups are wiped out. Production declines drastically (sending up prices further), as people lose the incentive to work—since they must spend much of their time getting rid of money. The main desideratum becomes getting hold of real goods, whatever they may be, and spending money as soon as received. When this runaway stage is reached, the economy in effect breaks down, the market is virtually ended, and society reverts to a state of virtual barter and complete impoverishment. Commodities are then slowly built up as media of exchange. The public has rid itself of the inflation burden by its ultimate weapon: lowering the demand for money to such an extent that the government’s money has become worthless. When all other limits and  forms of persuasion fail, this is the only way—through chaos and economic breakdown—for the people to force a return to the “hard” commodity money of the free market.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar's ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 1020-1021.

The Public Has a Weapon to Combat a Government That Uses Inflation As a Permanent Form of Taxation

Eventually, the public begins to realize what is taking place. It seems that the government is attempting to use inflation as a permanent form of taxation. But the public has a weapon to combat this depredation. Once people realize that the government will continue to inflate, and therefore that prices will continue to rise, they will step up their purchases of goods. For they will realize that they are gaining by buying now, instead of waiting until a future date when the value of the monetary unit will be lower and prices higher. In other words, the social demand for money falls, and prices now begin to rise more rapidly than the increase in the supply of money. When this happens, the confiscation by the government, or the “taxation” effect of inflation, will be lower than the government had expected, for the increased money will be reduced in purchasing power by the greater rise in prices. This stage of the inflation is the beginning of hyperinflation, of the runaway boom.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar's ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 1019-1020.

Credit Contraction Takes Away from the Original Coercive Gainers and Benefits the Original Coerced Losers

It is true that deflation takes from one group and gives to another, as does inflation. Yet not only does credit contraction speed recovery and counteract the distortions of the boom, but it also, in a broad sense, takes away from the original coercive gainers and benefits the original coerced losers. While this will certainly not be true in every case, in the broad sense much the same groups will benefit and lose, but in reverse order from that of the redistributive effects of credit expansion. Fixed-income groups, widows and orphans, will gain, and businesses and owners of original factors previously reaping gains from inflation will lose. The longer the inflation has continued, of course, the less the same individuals will be compensated.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar's ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 1007.

How Can the United States and the World Rid Itself of this Disease — Asset Price Inflation?

There is also a bigger aim. How can the US and the world rid itself of this disease — asset price inflation? It is not enough just to say “End the Fed.” First, a keen and widespread awareness must emerge that the Fed has indeed been responsible for spreading a deadly plague of market irrationality which has undermined economic prosperity and become a danger to economic and political freedoms.

A key step in creating awareness about this plague should be the exposure of deflation phobia as prevalent amongst leading monetary officials. Asset price inflation in modern times has originated always in a context where the Fed is fighting against an “incipient danger of deflation” — trying to stabilize prices or even push them up by 2% p.a. when the natural rhythm would have been downward for some time. Yet in today’s world of information technology, this phobia of deflation becomes harder and harder to comprehend.

In this latest period of monetary experimentation led by the Federal Reserve, the central bankers have sought to terrify their audiences about widespread price falls and so justify their quantitative easing policies and use of other non-conventional tools, including negative interest rates.

—Brendan Brown, introduction to A Global Monetary Plague: Asset Price Inflation and Federal Reserve Quantitative Easing (Houndmills, UK: Palgrave Macmillan, 2015), 3.

In the Prewar Years, People Would Plunk Down a $20 Gold Coin on the Shopkeeper’s Counter; It Rang; Hence, “Sound” Money

Gold was the coin of the realm in those prewar years. People would pull a $20 gold coin from their pocket and plunk it down on the shopkeeper’s counter. So struck, the coin rang; hence, “sound” money. Or, more likely, a shopper would produce a paper bill from his or her wallet, paper being more portable than coin. There were national bank notes, silver certificates, Treasury certificates and—once the Fed was up and running—Federal Reserve notes, not to mention checks drawn on a bank account. Paper dollars they were to the touch, but each was ultimately exchangeable, at the option of the holder, into gold. Gold coins themselves accounted for 16 percent of the 1913 supply of circulating American money.

—James Grant, The Forgotten Depression 1921: The Crash That Cured Itself (New York: Simon and Schuster, 2014), e-book.

Governments Are Actually Destroying the Foundations of Society with Their Current Policies of Negative Interest Rates

Since negative interest rates can only exist from state intervention, they are just a euphemism for a tax on savings. What impact do you believe they will have on the economy as they discourage savings and capital formation?

The longer it goes on, the sooner the countries that have negative interest rates are going to start looking like Third World countries. One of the reasons Third World countries are backward is that they don’t have any domestic capital. Why not? Because there aren’t domestic savings. And it takes capital to build things.

Governments are actually destroying the foundations of society with their current policies. It will take a while to happen in the West, because of the tremendous amount of capital that’s been accumulated and saved up over hundreds of years. But sure, they can absolutely destroy it. The Romans did it 2,000 years ago. The Venezuelans and Argentines are showing how to do it today.

—Doug Casey, “Doug Casey on the Disturbing Trend to Tax Savings and Eliminate Cash,” LewRockwell.com, entry posted April 2, 2020, https://www.lewrockwell.com/2020/04/doug-casey/doug-casey-on-the-disturbing-trend-to-tax-savings-and-eliminate-cash/ (accessed April 2, 2020).

Negative Interest Rates Disguise Government Bankruptcy and They Encourage People to Consume, Not Save

The whole financial world is in a bubble because of the trillions of currency units created since the crisis unfolded in 2008. Bonds are in a hyper bubble—the worst possible place to be. They’re a triple threat to capital—interest rate risk, currency risk, and default risk. And, again, at negative rates, they are truly a return-free risk.

Negative interest rates are being enforced by governments and central banks for several reasons.

First of all, governments are so head over heels in debt that they can’t afford to pay actual market-based interest rates.

If the US government, for instance, was paying even 6%, historically a more or less normal interest rate, on its $23 trillion of debt, that would be about $1.5 trillion a year in interest. That, just by itself, would more than double the current annual deficit.

That’s one reason governments like negative interest rates: it disguises their bankruptcy. They live on borrowed money. Tax revenues are nowhere near adequate to fund their spending—not to mention that spending is going to skyrocket while their revenues plunge for the foreseeable future.

Another reason governments like negative interest rates is that they encourage people to consume as opposed to save, which is also bizarro-world stupid. The only way you grow wealth is by producing more than you consume and saving the difference. The problem is that in today’s world the way to save is in currency in a bank account. If the currency loses value simultaneously with negative interest rates reducing the number of units, savings will drop.

If you’re penalized for saving, you’re going to do less of it. You’re going to go out and spend the money now on a bigger house, a new car, or perhaps a wild party. This is one reason why Third World countries never progress on their own. Their currencies are unstable, worthless, and not worth the trouble of people saving them. So, they never develop a capital base. It’s why poor people with bad habits stay poor.

From every economic point of view, negative interest rates are pure destruction. They make everything worse for prudent savers and better for profligate borrowers. But printing money and lowering rates are the only things that central banks can do to ward off a deflationary collapse. Their actions will only deepen and lengthen the Greater Depression.

—Doug Casey, “Doug Casey on the Disturbing Trend to Tax Savings and Eliminate Cash,” LewRockwell.com, entry posted April 2, 2020, https://www.lewrockwell.com/2020/04/doug-casey/doug-casey-on-the-disturbing-trend-to-tax-savings-and-eliminate-cash/ (accessed April 2, 2020).

Canadian Banks Rely More on Deposits to Finance Their Operations Than on Repurchase Agreements (Repos) in the Money Markets

The government ends up with a more subdued competition among the banks. It is a situation in which the banks are not obliged to extend especially risky loans in the pursuit of profit. This risk reduction is compounded by the Canadian regime’s long-standing sanctioning of national branch banking, which enables financial institutions to geographically diversify their loans. As if that were not enough, the banks are left with a secure source of funding, with much of the public’s savings deposited with them, a circumstance aided by the historical accident of Canada not having developed deep financial markets that could otherwise entice away more of people’s nest eggs. Indeed, an IMF research paper identified the Canadian banks’ greater reliance on deposits to finance their operations, instead of repurchase agreements (repos) in the money markets, as decisive in rendering them sturdier than their American counterparts during the recent financial maelstrom (Ratnovski & Huang, 2009). What the IMF only hinted at was that this source of over-all stability on the liabilities side of bank balance sheets was reinforced by an analogous source on the assets side, and that both were the consequence of political dynamics culminating in the maintenance of an oligopoly in banking.

—George Bragues, “The Political Regime Factor in Austrian Business Cycle Theory: Historically Accounting for the US and Canadian Experiences of the 2007-2009 Financial Crisis,” in Studies in Austrian Macroeconomics, ed. Steven Horwitz, Advances in Austrian Economics 20 (Bingley, UK: Emerald Group Publishing, 2016), 153-154.

This Is Quantitative Easing (QE) on Steroids Because It Is Permanent Just Like in Any Banana Republic

When the New York Federal Reserve began pumping billions of dollars a day into the repurchasing (repo) markets (the market banks use to make short-term loans to each other) in September [2019], they said this would only be necessary for a few weeks. Yet, last Wednesday, almost two months after the Fed’s initial intervention, the New York Federal Reserve pumped 62.5 billion dollars into the repo market.

The New York Fed continues these emergency interventions to ensure “cash shortages” among banks don’t ever again cause interest rates for overnight loans to rise to over 10 percent, well above the Fed’s target rate. . . .

One cause of the repo market’s sudden cash shortage was the large amount of debt instruments issued by the Treasury Department in late summer and early fall. Banks used resources they would normally devote to private sector lending and overnight loans to purchase these Treasury securities. This scenario will likely keep recurring as the Treasury Department will have to continue issuing new debt instruments to finance continuing increases in in government spending. . . .

Joseph Zidle, a strategist with the Blackstone investment firm, has called the government — or “sovereign” — debt bubble the “mother of all bubbles.” When the sovereign debt bubble inevitably busts, it will cause a meltdown bigger than the 2008 crash.

US consumer debt — which includes credit cards, student loans, auto loans, and mortgages — now totals over 14 trillion dollars. This massive government and private debts put tremendous pressure on the Federal Reserve to keep interest rates low or even to “experiment” with negative rates. But, the Fed can only keep interest rates, which are the price of money, artificially low for so long without serious economic consequences.

According to Michael Pento, the Fed is panicking in an effort to prevent economic trouble much worse than occurred in 2008. “It’s not just QE,” says Pento, “it’s QE on steroids because everybody knows that this QE is permanent just like any banana republic would do, or has done in the past.”

Congress will not cut spending until either a critical mass of Americans demand they do so, or there is a major economic crisis. In the event of a crisis, Congress will try to avoid directly cutting spending, instead letting the Federal Reserve do its dirty work via currency depreciation. This will deepen the crisis and increase support for authoritarian demagogues. The only way to avoid this is for those of us who know the truth to spread the message of, and grow the movement for, peace, free markets, limited government, and sound money.

—Ron Paul, “Is the ‘Mother of All Bubbles’ About to Pop?” The Power and Market Blog, entry posted November 14, 2019, https://mises.org/power-market/%E2%80%98mother-all-bubbles%E2%80%99-about-pop (accessed April 1, 2020).

3 Bond-Rating Corporations, Protected from Competition by SEC Regulations, Gave Triple-A Ratings on Mortgage-Backed Securities

The role of incentives is explicitly considered in Friedman and Kraus (2011); these authors embrace the regulatory failure thesis. In particular they debunk various elements of the conventional wisdom about what caused the financial crisis and argue that the crisis was a regulatory failure in which the prime culprit was the set of regulations governing banks’ capital levels known as the Basel rules. Theirs is an “incentives story” but it is not a moral-hazard story. They stress the role of radical ignorance on all sides. The triple-A ratings on MBS were conferred by three bond-rating corporations that had been protected from competition by Securities and Exchange Commission regulation dating back to 1975. Not only bankers but investors of all kinds were either unaware that these three corporations were protected, or they were unaware of the implications of this protection for the accuracy of their ratings. This lack of awareness was apparently shared by the banking regulators, who had incorporated the three companies’ ratings into the Recourse Rule and Basel II. The financial crisis was transmitted into the nonfinancial or “real” economy through a lending contraction that began in mid-2007, as banks were required to “mark to market” their holdings of mortgage-backed securities in line with market fears about the value of these securities, due to rising rates of subprime mortgage delinquencies.

—Ludwig Van Den Hauwe, “Understanding Financial Instability: Minsky Versus the Austrians,” in “Revisiting the Hayek-Keynes Debate in Light of the 2008-2010 Crisis,” special issue, Journal des Économistes et des Études Humaines 22, no. 1 (2016): 51.

The March 2009 Mont Pelerin Society Focused on Whether the Great Recession Was Best Explained by the Austrian School

An important conference put on in March 2009 by the Mont Pelerin Society focused on whether the Great Recession was best explained by Austrian economic analysis or that of another school, Keynesian or otherwise. In a seminal paper, Axel Leijohnufvud (2009) examined whether the downturn was one best analyzed by an income-expenditure model, i.e., in terms of economic flows. He concluded that it was not. Instead, he declared it to be a classic balance-sheet recession, and one best analyzed by Austrian analysis.

All of the macroeconomic policies implemented in the Great Recession ignored its character as a balance-sheet recession. When households and businesses are trying to restore their balance sheets and rebuild savings, creating massive new federal debt is counterproductive. But creating future tax obligations for households and businesses is precisely what the stimulus did. There were also other, deleterious microeconomic effects that put more of the burden of adjustment on the private sector. Much of the federal spending went to prop up state government spending on public-sector workers. That forced the private sector to bear more of the adjustment costs.

Many chide Austrian economists for not having a positive policy to cushion against the effects of the Great Recession. They did have a policy. It was to facilitate and not to impede the adjustments in asset markets.

First, do no harm. The macroeconomic response was largely harmful. In the second half of 2008, the Federal Reserve responded appropriately to provide more liquidity. After that, its various QEs were misbegotten. The economy was not suffering from a lack of liquidity, but the aftermath of a severe collapse in the prices of many assets. Financial institutions and other firms were insolvent, not illiquid. Additionally, the Federal Reserve policy of very low interest rates (negative in real terms) distorts capital allocation and creates new malinvestments.

—Gerald P. O'Driscoll Jr. and Mario J. Rizzo, introduction 2014 to Austrian Economics Re-Examined: The Economics of Time and Ignorance, Routledge Foundations of the Market Economy 33 (London: Routledge, Taylor and Francis, 2015), 8.

Home Mortgages Were Financed by Short-Term Credit, Even Overnight Funding, Made Famous by Lehman Brothers

The financial crisis began with the Panic of 2007, and continued into 2008 with multiple crisis events involving, among others, mortgage giants Fannie Mae and Freddie Mac; failed investment banks like Bear Stearns (bailed out) and Lehman Brothers (not bailed out); and many financial firms whose solvency was in doubt at some point (e.g., Citigroup and Morgan Stanley). The Panic involved a great housing boom financed by innovative financial instruments. After the housing boom ended there was a crisis in housing finance involving actual or perceived insolvency of firms at the center of housing finance.

The crisis occurred in the midst of a period known as the Great Moderation. It was a period in which the growth rates of monetary aggregates moderated. Macroeconomic flow variables, like real GDP,  became less volatile. But it was also a period of a great expansion in the velocity of the M1 monetary aggregate.

The increase in velocity, or decrease in money demand, accompanied the rise of “shadow banking,” in which housing loans (and other bank lending) were securitized. Long-term debt, like home mortgages, was increasingly financed by short-term credit, even overnight funding as was so famously the case with Lehman Brothers. A credit pyramid was erected upon a narrow base of bank money. The possession of Treasury securities or other eligible collateral financed transactions in repo (overnight repurchase agreements) markets. Gorton succinctly described the process.

Another important feature of repo is that the collateral can be rehypothecated. In other words, the collateral received by the depositor can be used — “spent” — in another transaction, i.e., it can be used to collateralize a transaction with another party. Intuitively, rehypothecation is tantamount to conducting transactions with the collateral received against the deposit. There is no data on the extent of rehypothecation. (Gorton, 2010, p. 44)

—Gerald P. O'Driscoll Jr. and Mario J. Rizzo, introduction 2014 to Austrian Economics Re-Examined: The Economics of Time and Ignorance, Routledge Foundations of the Market Economy 33 (London: Routledge, Taylor and Francis, 2015), 4-5.

The Repo Crisis Tells Us the Assets Used as Collateral and the Borrowers’ Ability to Repay Are ALL Artificially Manipulated

The repo market is where borrowers seeking cash offer lenders collateral in the form of safe securities. Repo rates are the interest rate paid to borrow cash in exchange for Treasuries for 24 hours. . . .

When did hedge funds and other liquidity providers stop accepting Treasuries for short-term operations? It is easy money! You get a safe asset, provide cash to borrowers, and take a few points above and beyond the market rate. Easy money. Are we not living in a world of thirst for yield and massive liquidity willing to lend at almost any rate?

Well, it would be easy money . . .  Unless all the chain in the exchange process is manipulated and rates too low for those operators to accept even more risk.

In essence, what the repo issue is telling us is that the Fed cannot make magic. The central planners believed the Fed could create just the right inflation, manage the curve while remaining behind it, provide enough liquidity but not too much while nudging investors to longer-term securities. Basically, the repo crisis — because it is a crisis — is telling us that liquidity providers are aware that the price of money, the assets used as collateral and the borrowers’ ability to repay are all artificially manipulated. That the safe asset is not as safe into a recession or global slowdown, that the price of money set by the Fed is incoherent with the reality of the risk and inflation in the economy, and that the liquidity providers cannot accept any more expensive “safe” assets even at higher rates because the rates are not close to enough, the asset is not even close to being safe, and the debt and risk accumulated in other positions in their portfolio is too high and rising.

—Daniel Lacalle, “The Repo Crisis Shows the Damage Done by Central Bank Policies,” Mises Wire, entry posted October 11, 2019, https://mises.org/wire/repo-crisis-shows-damage-done-central-bank-policies (accessed March 30, 2020).

Bear Stearns and the Boston Fed Used “Politically Correct Doublespeak” to Defend the Soundness of Mortgage-Backed Securities

Fannie and Freddie weren’t the only entities in Washington pushing for looser lending requirements. Government agencies of various kinds were pressuring lenders into making riskier loans in the name of “racial equality.” Not wanting to be on the wrong end of lawsuits demanding hundreds of millions in damages, these lenders did as they were told.

Charges of racial discrimination in lending helped spur this rush. In 1992, a study by the Federal Reserve Bank of Boston claimed to find evidence that even allowing for differences in creditworthiness, minority applicants were still getting mortgage loans at lower rates than whites. That study was widely hailed as definitive by those who wanted to believe its conclusions, that American banks were guilty of discrimination against blacks and Hispanics (though not against Asians, who got mortgage loans at even higher rates than whites), and should be forced to make credit more widely available to people in inner-city neighborhoods. Evidence later surfaced exposing the sloppiness of the study, and showing that no evidence of discrimination was found when errors in the data were corrected, but it was too late. The pressure groups had their bludgeon and intended to use it.

The Community Reinvestment Act (CRA), a Jimmy Carter-era law that was given new life by the Clinton administration, has received a great deal of attention and criticism since the housing bust began. That law opened banks up to crushing discrimination suits if they did not lend to minorities in numbers high enough to satisfy the authorities. But it wasn’t just the CRA that was pushing lower lending standards. It was the entire political establishment. And according to the University of Texas's Stan Liebowitz, one thing a scan of the housing literature from 1990 until 2006 will not yield is any suggestion that “perhaps these weaker lending standards that every government agency involved with housing tried to advance, that Congress tried to advance, that the presidency tried to advance, that the GSEs tried to advance-and with which the penitent banks initially went along and eventually supported with enthusiasm-might lead to high defaults, particularly if housing prices should stop rising.”

Shortly after its discrimination study was published, the Boston Fed also released a manual for banks on nondiscriminatory mortgage lending. It explained that banks would have trouble attracting business from minority customers if its lending criteria contained “arbitrary or unreasonable measures of creditworthiness.” We can safely assume that banks did not need to be told that “arbitrary or unreasonable measures of creditworthiness” were bad for the banking business. What the Boston Fed really meant, of course, was that the bank’s standards were clearly “arbitrary or unreasonable” if minority customers were not receiving a significant percentage of the bank's loans. The rest of the manual was filled with the same kind of politically correct doublespeak — about credit history, down payments, and traditional sources of income, all of which were presented as dispensable obstacles in the way of increased homeownership among society’s least advantaged.

Naturally, banks did what government regulators wanted them to do. “Banks began to loosen lending standards,” says Liebowitz. “And loosen and loosen, to the cheers of the politicians, regulators, and GSEs [Government-Sponsored Enterprises].” Bear Stearns, a major underwriter of mortgage-backed securities, argued for the soundness of these mortgages on the same Orwellian grounds as the Boston Fed. The credit rating of a borrower shouldn't be so important, their literature explained. “CRA loans do not fit neatly into the standard credit score framework.” And so on through the whole roster of traditional lending standards.

—Thomas E. Woods Jr., Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Washington, DC: Regnery Publishing, 2009), 17-18.

The Subprime Crisis Began in June 2007 When Merrill Lynch Asked Bear Stearns’s Hedge Funds for More Collateral

Since the subprime mortgage market began to turn sour in the early summer of 2007, shockwaves have been spreading through all the world’s credit markets, wiping out some hedge funds and costing hundreds of billions of dollars to banks and other financial companies. The main problem lay with CDOs [Collateralized Debt Obligations], over half a trillion dollars of which had been sold in 2006, of which around half contained subprime exposure. It turned out that many of these CDOs had been seriously over-priced, as a result of erroneous estimates of likely subprime default rates. As even triple-A-rated securities began going into default, hedge funds that had specialized in buying the highest-risk CDO tranches were the first to suffer. Although there had been signs of trouble since February 2007, when HSBC admitted to heavy losses on US mortgages, most analysts would date the beginning of the subprime crisis from June of that year, when two hedge funds owned by Bear Stearns were asked to post additional collateral by Merrill Lynch, another investment bank that had lent them money but was now concerned about their excessive exposure to subprime-backed assets. Bear bailed out one fund, but let the other collapse. The following month the ratings agencies began to downgrade scores of RMBS CDOs (short for ‘residential mortgage-backed security collateralized debt obligations,’ the very term testifying to the over-complex nature of these products). As they did so, all kinds of financial institutions holding such assets found themselves staring huge losses in the face. The problem was greatly magnified by the amount of leverage (debt) in the system. Hedge funds in particular had borrowed vast sums from their prime brokers — banks — in order to magnify the returns they could generate. The banks, meanwhile, had been disguising their own exposure by parking subprime-related assets in off-balance-sheet entities known as conduits and strategic investment vehicles (SIVs, surely the most apt of all the acronyms of the crisis), which relied for funding on short-term borrowings on the markets for commercial paper and overnight interbank loans. As fears rose about counterparty risk (the danger that the other party in a financial transaction may go bust), those credit markets seized up.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 271-272.

The Process of “Securitization” Was to Reinvent Mortgages and to Convert Mortgages into Bonds

The idea was to reinvent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds — in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into ‘strips’ with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a collateralized mortgage obligation) happened in June 1983. It was the dawn of a new era in American finance.

The process was called securitization and it was an innovation that fundamentally transformed Wall Street, blowing the dust off a previously sleepy bond market and ushering in a new era in which anonymous transactions would count for more than personal relationships. Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie or Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtually government bonds, and hence ‘investment grade.’ Between 1980 and 2007 the volume of such GSE-backed mortgage-backed securities grew from $200 million to $4 trillion. With the advent of private bond insurers, firms like Salomon could also offer to securitize so-called nonconforming loans not eligible for GSE guarantees. By 2007 private pools of capital sufficed to securitize $2 trillion in residential mortgage debt. In 1980 only 10 per cent of the home mortgage market had been securitized; by 2007 it had risen to 56 per cent.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 259-260.

‘Subprime’ Mortgages Were Typically Both Adjustable-Rate (ARMs) and Interest-Only Mortgages with ‘Teaser’ Periods

‘Subprime’ mortgage loans are aimed by local brokers at families or neighbourhoods with poor or patchy credit histories. Just as jumbo mortgages are too big to qualify for Fannie Mae’s seal of approval (and implicit government guarantee), subprime mortgages are too risky. Yet it was precisely their riskiness that made them seem potentially lucrative to lenders. These were not the old thirty-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages (ARMs) — in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 per cent of the assessed value of the mortgaged property. And most had introductory ‘teaser’ periods, whereby the initial interest payments — usually for the first two years — were kept artificially low, back-loading the cost of the loan. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower. But the small print of subprime contracts implied major gains for the lender. One particularly egregious subprime loan in Detroit carried an interest rate of 9.75 per cent for the first two years, but after that a margin of 9.125 percentage points over the benchmark short-term rate at which banks lend each other money: conventionally the London interbank offered rate (Libor). Even before the subprime crisis struck, that already stood above 5 per cent, implying a huge upward leap in interest payments in the third year of the loan.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 264-265.