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sell the home before the sixth year at a profit. But by 2006, the housing
bubble was topping out; and as in every Ponzi scheme, the vulnerable
buyers who got in last would be left holding the bag when the bubble
collapsed.
Even borrowers with fixed rate mortgages can wind up paying
quite a bit more than they anticipated for their homes. Loans are
structured so that the borrower who agrees to a 30-year mortgage at a
fixed rate of 7 percent will actually pay about 2-1/2 times the list price
of the house over the course of the loan. A house priced at $330,000

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at 7 percent interest would accrue $460,379.36 in interest, for a total
tab of $790,379.36.6 The bank thus actually gets a bigger chunk of the
pie than the seller, although it never owned either the property or the
loan money, which was created as it was lent; and home loans are
completely secured, so the risk to the bank is very low. The buyer will
pay about 2-1/2 times the list price to borrow money the bank never
had until the mortgage was signed; and if he fails to pay the full 250
percent, the bank may wind up with the house.
For the first five years of a thirty-year home mortgage, most of the
buyer™s monthly payments consist of interest. For ARMs, the loans
may be structured so that the first five years™ payments consist only of
interest, with a variable-rate loan thereafter. Since most homes change
hands within five years, the average buyer who thinks he owns his
own home finds on resale that most if not all of the equity still belongs
to the lender. If interest rates have gone up in the meantime, home
values will drop, and the buyer will be locked into higher payments
for a less valuable house. If he has taken out a home loan for “equity”
that has subsequently disappeared, he may have to pay the difference
on sale of the home. And if he can™t afford that balloon payment, he
will be reduced to home serfdom, strapped in a home he can™t afford,
working to make his payments to the bank. William Hope Harvey™s
dire prediction that workers would become wage-slaves who owned
nothing of their own would have materialized.
The Homestead Laws that gave settlers their own plot of land have
been largely eroded by 150 years of the “business cycle,” in which
bankers have periodically raised interest rates and called in loans, cre-
ating successive waves of defaults and foreclosures. For most fami-
lies, the days of inheriting the family home free and clear are a thing
of the past. Some individual homeowners have made out well from
the housing boom, but the overall effect has been to put the average
family on the hook for a substantially more expensive mortgage than
it would have had a decade ago. Again the real winners have been
the banks. As market commentator Craig Harris explained in a March
2004 article:
Essentially what has happened is that there was a sort of stealth
transfer of net worth from the public to the banks to help save
the system. The public took on the risk, went further into debt,
spent a lot of money . . . and the banks™ new properties have
appreciated substantially. . . . They created the money and lent
it to you, you spent the money to prop up the economy, and

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now they own the real property and you™re on the hook to pay
them back an inflated price [for] that property . . . They gave
you a better rate but you paid more for the property which they
now own until you pay them back.7

The Impending Tsunami of Sub-prime Mortgage Defaults

The larger a pyramid scheme grows, the greater the
number of investors who need to be brought in to support the pyramid.
When the “prime” market was exhausted, lenders had to resort to the
riskier “sub-prime” market for new borrowers. Risk was off-loaded
by slicing up these mortgages and selling them to investors as
“mortgage-backed securities.” “Securitizing” mortgages and selling
them to investors was touted as “spreading the risk,” but the device
backfired. It wound up spreading risk like a contagion, infecting
investment pools ranging from hedge funds to pension funds to money
market funds.
In a November 2005 article called “Surreal Estate on the San
Andreas Fault,” Gary North estimated that loans related to the housing
market had grown to 80 percent of bank lending, and that much of
this growth was in the sub-prime market, which had been hooked
with ARMs that were quite risky not only for the borrowers but for
the lenders. North said prophetically:
. . . Even without a recession, the [housing] boom will falter
because of ARMs . . . . These time bombs are about to blow,
contract by contract.
If nothing changes -- if short-term rates do not rise -- monthly
mortgage payments are going to rise by 60% when the readjustment
kicks in. Yet buyers are marginal, people who could not qualify
for a 30-year mortgage. This will force “For Sale” signs to flower
like dandelions in spring. . . .
If you remember the S&L [savings and loan association] crisis
of the mid-1980s, you have some indication of what is coming.
The S&L crisis in Texas put a squeeze on the economy in Texas.
Banks got nasty. They stopped making new loans. Yet the S&Ls
were legally not banks. They were a second capital market.
Today, the banks have become S&Ls. They have tied their loan
portfolios to the housing market.
I think a squeeze is coming that will affect the entire banking
system. The madness of bankers has become unprecedented. . .
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Banks will wind up sitting on top of bad loans of all kinds because
the American economy is now housing-sale driven.8
The savings and loan industry collapsed after interest rates were
raised to unprecedented levels in the 1980s. The commercial banks™
prime rate (the rate at which they had to borrow) reached 20.5 percent
at a time when the S&Ls were earning only about 5 percent on
mortgage loans made previously, and the negative spread caused them
huge losses. Although banks in recent years have off-loaded mortgages
by selling them to investors, the banks may still be liable in the event of
default; and even if they™re not, they could find themselves defending
some very large lawsuits, as we™ll see shortly. The banks themselves
are also heavily invested in securities infected with subprime debt.
By January 2007, the housing boom had substantially cooled, after
a series of interest rate hikes were imposed by the Fed. An article in
The New York Times that month warned,“1 in 5 sub-prime loans will
end in foreclosure . . . . About 2.2 million borrowers who took out sub-
prime loans from 1998 to 2006 are likely to lose their homes.” In an
editorial the same month, Mike Whitney noted that when family
members and other occupants are included, that could mean 10 million
people turned out into the streets; and some analysts thought even
that estimate was low. Whitney quoted Peter Schiff, president of an
investment strategies company, who warned, “The secondary effects
of the ˜1 out of 5™ sub-prime default rate will be a chain reaction of
rising interest rates and falling home prices engendering still more
defaults, with the added foreclosures causing the cycle to repeat. In
my opinion, when the cycle is fully played out we are more likely to
see an 80% default rate rather than 20%.” Whitney commented:
40 million Americans headed towards foreclosure? Better pick
out a comfy spot in the local park to set up the lean-to. Schiff™s
calculations may be overly pessimistic, but his reasoning is sound.
Once mortgage-holders realize that their homes are worth tens
of thousands less than the amount of their loan they are likely to
“mail in their house keys rather than make the additional
mortgage payments.” As Schiff says, “Why would anyone
stretch to spend 40% of his monthly income to service a $700,000
mortgage on a condo valued at $500,000, especially when there
are plenty of comparable rentals that are far more affordable?”9
As with the Crash of 1929, the finger of responsibility is being
pointed at the Federal Reserve, which blew up the housing bubble
with “easy” credit, then put a pin in it by making credit much harder
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to get. Whitney writes:
[The Fed] kept the printing presses whirring along at full-tilt
while the banks and mortgage lenders devised every scam
imaginable to put greenbacks into the hands of unqualified
borrowers. ARMs, “interest-only” or “no down payment” loans
etc. were all part of the creative financing boondoggle which
kept the economy sputtering along after the “dot.com” crackup
in 2000.
. . . Now, many of those same buyers are stuck with enormous
loans that are about to reset at drastically higher rates while
their homes have already depreciated 10% to 20% in value. This
phenomenon of being shackled to a “negative equity mortgage”
is what economist Michael Hudson calls the “New Road to
Serfdom”; paying off a mortgage that is significantly larger than
the current value of the house. The sheer magnitude of the
problem is staggering.
The ability to adjust interest rates is considered a necessary and
proper tool of the Fed in managing the money supply, but it is also a
form of arbitrary manipulation that can be used to benefit one group
over another. The very notion that we have a “free market” is belied
by the fact that investors, advisers and market analysts wait with bated
breath to hear what the Fed is going to do to interest rates from month
to month. The market is responding not to supply and demand but to
top-down dictatorial control. Not that that would be so bad if it actu-
ally worked, but a sinking economy can™t be kept afloat merely by
adjusting interest rates. The problem has been compared to “pushing
on a string”: when credit (or debt) is the only way to keep money in
an economy, once borrowers are “all borrowed up” and lenders have
reached their lending limits, no amount of lowering interest rates will
get more debt-money into the system. Lenders managed to get around
the lending limits by moving loans off their books and selling them to
investors, but when the investors learned that the loans were “toxic”
-- infected with risky subprime debt -- they quit buying, putting the
“credit market” (or debt market) at risk of seizing up altogether. The
only solution to this conundrum is to get “real” money into the system
-- real, interest-free, debt-free, government-issued legal tender of the
sort first devised by the American colonists.
By 2005, financial weather forecasters could see two economic
storm fronts forming on the horizon, and both were being blamed on
the market manipulations of the Fed . . . .

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Chapter 31
THE PERFECT FINANCIAL STORM


Uncle Henry sat upon the doorstep and looked anxiously at the
sky, which was even grayer than usual. . . . “There™s a cyclone coming,
Em,” he called to his wife. . . . Aunt Em dropped her work and came
to the door. . . . “Quick, Dorothy!” she screamed. “Run for the cellar!”
“ The Wonderful Wizard of Oz,
“The Cyclone”




T he rare weather phenomenon known as “the perfect storm”
occurs when two storm fronts collide. What analysts are calling
“the perfect financial storm” is the impending collision of the two
economic storm fronts of inflation and deflation. The American money
supply is being continually pumped up with new money created as
loans, but borrowers are increasingly unable to repay their loans, which
are going into default. When loans are extinguished by default, the
money supply contracts and deflation and depression result. The
collision of these two forces can result in “stagflation” “ price inflation
without economic growth. That is a “category 1” financial storm. A
“category 5” storm might result from a derivatives crisis in which major
traders defaulted on their bets, or from a serious decline in the housing
market. In a June 2005 newsletter, Al Martin stated that the General
Accounting Office, the Office of the Comptroller of the Currency, and
the Federal Housing Administration had privately warned that a
decline of as much as 40 percent could occur in the housing market
between 2005 and 2010. A housing decline of that magnitude could
collapse the economy of the United States.1




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Chapter 31 - The Perfect Financial Storm

The Debt Crisis and the Housing Bubble

After a series of changes beginning in 2001 dropping the federal
funds rate to unprecedented lows, housing prices began their inexorable
climb, aided by a loosening of lending standards. Adjustable-rate loans,
interest only loans, and no down payment loans drew many new home
buyers into the market, putting steady upward pressure on prices.
Soaring housing prices, in turn, deepened the debt crisis. To keep all
this new debt-money afloat required a steady stream of new borrowers,
prompting lenders to offer loans to shaky borrowers on more and more
lax conditions. In 2005, a Mortgage Bankers Association survey found
that high-risk adjustable and interest-only loans had grown to account
for nearly half of new loan applications. Federal Reserve Governor
Susan Schmidt Bies, speaking in October 2005, said that average U.S.
housing prices had appreciated by more than 80 percent since 1997.
Rock-bottom interest rates salvaged stock market speculators and
big investment banks from the 2000 recession, and they allowed some
politically-popular tax cuts that favored big investors; but they were
disastrous for the bond market, where retired people have traditionally
invested for a safe and predictable return on their savings. By 2004,
real returns after inflation on short-term interest rates were negative.2
(That is, if you lent $100 to the government by buying its bonds this
year, your investment might grow to be worth $102 next year; but
after inflation it would be worth only $98.) The result was to force
retired people living on investment income out of the reliable bond
market into the much riskier stock market. Today stocks are owned
by over half of Americans, the highest number in history.
The Fed™s low-interest policies also discouraged foreign investors
from buying U.S. bonds, and that is what precipitated the second
financial storm front. Foreign investment money is relied on by the
government to roll over its ballooning debt. New bonds must
continually be sold to investors to replace the old bonds as they come
due. The Fed has therefore been under pressure to raise interest rates,
both to attract foreign investors and to keep a lid on inflation. Higher
interest rates, however, mean that increasing numbers of homes will
go into foreclosure; and when mortgages are voided out, the supply of
credit-money they created shrinks with them. Although the sellers
have been paid and the old loan money is still in the system, the banks
have to balance their books, which means they can create less money
in the form of new loans; and borrowers are harder to find, because

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