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An Extreme Example of Poor Risk Management


What Happened to the American Economy?

October 2009 Official U.S. unemployment rate jumped to 10.2%. search
June 1, 2009
GM bankruptcy announced. search
April 30, 2009 Chrysler bankruptcy announced. search
Sept. 19, 2008 Treasury announces guaranty program for money market funds. search
Sept. 18, 2008 Run on money markets. search
Sept. 15, 2008 Lehman Brothers filed for Chapter 11 bankruptcy (case study). search
Sept. 7, 2008 Federal takeover of Fannie Mae and Freddie Mac, a conservatorship. search
July 17, 2007 Bear Stearns High-Grade Structured Credit Funds collapse (House of Cards). search

A Massive Economic Contraction!

Contraction in Percentage of U.S. Population Employed and U.S. Housing Starts
  

Why did this happen?
The economic contraction occurred because of poor risk management during the liberalization of financial markets.
There were too many unwise steps taken to reduce capital reserves for potentially high-risk loans.
 
Capital reserves are the money that banks and other financial institutions must keep on hand as a cushion against losses.

Brokerage Firms Government Sponsored Enterprises (GSE) Banks
NEW RULES

April 28, 2004
U.S. market regulators approved new rules that would let some major Wall Street brokerages reduce the amount of money they set aside as net capital, in some cases by as much as 30 percent. In a move in line with bank regulatory changes in Europe, the U.S. Securities and Exchange Commission voted unanimously in an open meeting to approve two optional sets of rules. Under one of them, five big U.S. brokerages could be designated as "consolidated supervised entities," or CSEs.

Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns expressed interest in CSE status. In line with new capital adequacy standards coming into force soon under Europe's Basel accords, brokerages granted CSE status would be able to use in-house, risk-measuring computer models to figure how much net capital they need to set aside. Under Basel standards, some institutions could cut their net capital by as much as 50 percent. But the SEC's new CSE rule added a $5-billion floor to the Basel model, reducing the likely level of reductions to 20 to 30 percent. 

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AFTER THE FALL

September 26, 2008
Securities and Exchange Commission Chairman Christopher Cox today announced a decision by the Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency's plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.

Chairman Cox made the following statement:

The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.

Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap.

As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.

The Inspector General of the SEC today released a report on the CSE program's supervision of Bear Stearns, and that report validates and echoes the concerns I have expressed to Congress. The report's major findings are ultimately derivative of the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.

With each of the major investment banks that had been part of the CSE program being reconstituted within a bank holding company, they will all be subject to statutory supervision by the Federal Reserve. Under the Bank Holding Company Act, the Federal Reserve has robust statutory authority to impose and enforce supervisory requirements on those entities. Thus, there is not currently a regulatory gap in this area.

The CSE program within the Division of Trading and Markets will now be ending.
 
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NEW RULES

March 19, 2008
OFHEO, Fannie Mae and Freddie Mac today announced a major initiative to increase liquidity in support of the U.S. mortgage market. The initiative is expected to provide up to $200 billion of immediate liquidity to the mortgage-backed securities market. 

OFHEO estimates that Fannie Mae’s and Freddie Mac’s existing capabilities, combined with this new initiative and the release of the portfolio caps announced in February, should allow the GSEs to purchase or guarantee about $2 trillion in mortgages this year. This capacity will permit them to do more in the jumbo temporary conforming market, subprime refinancing and loan modifications areas. 

To support growth and further restore market liquidity, OFHEO announced that it would begin to permit a significant portion of the GSEs’ 30 percent OFHEO-directed capital surplus to be invested in mortgages and MBS.
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AFTER THE FALL

September 7, 2008
In order to restore the balance between safety and soundness and mission, FHFA has placed Fannie Mae and Freddie Mac into conservatorship. That is a statutory process designed to stabilize a troubled institution with the 5 objective of returning the entities to normal business operations. FHFA will act as the conservator to operate the Enterprises until they are stabilized. 

The goal of these actions is to help restore confidence in Fannie Mae and Freddie Mac, enhance their capacity to fulfill their mission, and mitigate the systemic risk that has contributed directly to the instability in the current market.
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NEW RULES

1980-1992
The Monetary Control Act of 1980 (MCA) mandated universal reserve requirements to be set by the Federal Reserve for all depository institutions, regardless of their membership status. 

To ease the burden of reserve requirements, the MCA initially set the basic reserve requirement on transaction deposits at 12 percent — below the 16.25 percent maximum that had been in effect for member banks — and prohibited the Federal Reserve from raising this requirement above 14 percent. It also set a 3 percent reserve requirement on the first $25 million of deposits at each institution — the so-called low reserve tranche — as a special concession to smaller depositories. 

In 1982, the Garn–St Germain Act went even further by exempting from reserve requirements altogether the first $2 million of deposits. The law mandated annual adjustments to the cutoffs for the exemption and the low reserve tranche based on aggregate growth in reservable liabilities and transaction deposits respectively. To help smooth the transition for nonmember banks and thrift institutions, a multiyear phase-in period was put in place, and the Federal Reserve was also prohibited from putting reserve requirements on personal time and savings deposits, which were particularly important sources of funds for these institutions. 

In the decade after passage of the MCA in 1980, the Federal Reserve left reserve requirements essentially unchanged. More recently, however, it has taken two steps to reduce these requirements. In December 1990, the required reserve ratio on nontransaction accounts — nonpersonal time and savings deposits and net Eurocurrency liabilities — was pared from 3 percent to zero, and in April 1992, the 12 percent requirement on transaction deposits was trimmed to 10 percent.
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1994-2008
Since 1994, depository institutions have been able to lower required reserves without affecting customer liquidity by periodically reclassifying balances from retail transactions deposits into savings accounts. This practice, known as "sweeping," has grown rapidly, and, as a result, reserve requirements as a percentage of total liquid deposits have fallen dramatically.
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Since January 1994, the Federal Reserve Board has permitted depository institutions in the United States to implement so-called retail sweep programs. The essence of these programs is computer software that dynamically reclassifies customer deposits between transaction accounts, which are subject to statutory reserve requirement ratios as high as 10 percent, and money market deposit accounts, which have a zero ratio. Through the use of such software, hundreds of banks have sharply reduced the amount of their required reserves. In some cases, this new level of required reserves is less than the amount that the bank requires for its ordinary, day-to-day business. In the terminology introduced by Anderson and Rasche (1996b), such deposit-sweeping activity has allowed these banks to become “economically nonbound,” and has reduced to zero the economic burden (“tax”) due to statutory reserve requirements.
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Bank reserves effectively near zero for over a decade.

Required Reserves minus Vault Cash
source

During the 1990s, Federal Reserve publications have documented the spread of deposit-sweeping software through the U.S. banking industry. The July 1994 Humphrey-Hawkins Act monetary-policy report introduced deposit-sweep programs, in a single sentence. The July 1995 report noted that approximately $12 billion of deposits were involved in sweep activity and, as a result, that deposits at Federal Reserve Banks had decreased by about $1.2 billion. It also raised concern regarding an increase in federal funds rate volatility if deposits decreased further. The July 1996 report included a special appendix on the operation of sweep programs. The February 1997 report noted that the aggregate amount of deposits affected by sweep programs had increased to approximately $116 billion, compared to $45 billion in 1995. The July 1997 report noted the introduction of deposit-sweep programs for household demand deposits, and noted that some banks were increasing the size of their clearing balance contracts when sweep programs reduced their required reserves. Subsequent reports have repeated these themes, along with an appeal that the Congress allow the Federal Reserve to pay interest on reserve balances.
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AFTER THE FALL

October 6, 2008
The Federal Reserve Board announced that it will begin to pay interest on depository institutions' required and excess reserve balances.

The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.

Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions.
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What was done to address the economic contraction in 2008?
The monetary base was increased to cover the dangerous lack of capital reserves.
The U.S. Treasury created billions of additional dollars, and the Federal Reserve used the dollars to purchase high-risk loans from financial institutions, and provided overnight loans as needed, to keep the institutions solvent.
 

Massive Increase in the Monetary Base since 2008

Monetary Base (dollars in circulation and central banks' reserves)  source


Federal Reserve Assets 2007-2011 
source

 

After the collapse of Lehman Brothers in 2008, the Federal Reserve rapidly increased the monetary base to fund a variety of short-term programs to stabilize financial institutions by providing them with much needed reserves. Included were programs supporting banks, money market mutual funds, and primary dealers (Goldman Sachs, Morgan Stanley, Merrill Lynch, etc.) [see Chart D below]. Funds were also used to support foreign central banks through currency swaps. In 2009, as funding for the short-term programs was reduced, a massive transfer of high-risk ("toxic") mortgage-backed securities to the Federal Reserve occurred to provide banks with more excess reserves [see Charts D & E below].

 

High Excess Reserves of Depository Institutions since 2008

Excess Reserves of Depository Institutions   source

 

 

 

 

 

60 Minutes Asks Why Isn't Anybody in Jail for the Financial Crisis?
 
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Why all the risky loans?
The desire for "affordable" home loans was a key component of the economic contraction in 2008.
High-risk mortgage loans were pushed by a do-gooder federal government, and accepted by many borrowers and lenders.

As long as home values continued to increase, the high risks of many mortgage loans were "hidden" from view. Once home prices began to fall in 2007, an economic contraction was just around the corner.

U.S. House Price Index

House Price Index for the U. S.  source

 

 

What were borrowers and lenders thinking?

Mortgage Borrowers Federal Government Mortgage Lenders
A 20% mortgage loan down payment is "not fair".

Historically, mortgage borrowers were required to make a 20% down payment. The lender was protected from any potential loss in the mortgaged home value by lending out only 80% of the selling price. 

Many mortgage borrowers would like to avoid a 20% down payment, especially if they are first-time or low-income home buyers, and they were happy when mortgage lending practices changed to include...

NINA loans
A type of reduced documentation mortgage program in which no income and no assets are disclosed on the loan application, but employment is verified.

NINJA loans
A type of loan extended to a borrower with "no income, no job and no assets". 

For comparison, risk-averse lenders would require the borrower to verify a stable income and sufficient collateral, but a NINJA loan process ignores such verification.

125% loans
A mortgage loan with a borrowed amount equal to 125% of the initial property value. The borrower gets a mortgage loan with no down payment, and with an addition loaned amount for 25% of the value of the property being mortgaged.

 

Federal government "stability", "assistance" and "access" is created.

The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, have operated since 1968 as government sponsored enterprises (GSEs). This means that, although the two companies are privately owned and operated by shareholders, they are protected financially by the support of the Federal Government. These government protections include access to a line of credit through the U.S. Treasury, exemption from state and local income taxes and exemption from SEC oversight.

Fannie Mae was created in 1938 as part of Franklin Delano Roosevelt's New Deal. 

Initially, Fannie Mae operated like a national savings and loan, allowing local banks to charge low interest rates on mortgages for the benefit of the home buyer. This lead to the development of what is now known as the secondary mortgage market. Within the secondary mortgage market, companies such as Fannie Mae are able to borrow money from foreign investors at low interest rates because of the financial support that they receive from the U.S. Government. It is this ability to borrow at low rates that allows Fannie Mae to provide fixed interest rate mortgages with low down payments to home buyers. Fannie Mae makes a profit from the difference between the interest rates homeowners pay and foreign lenders charge.

For the first thirty years following its inception, Fannie Mae held a veritable monopoly over the secondary mortgage market. In 1968, due to fiscal pressures created by the Vietnam War, Lyndon B. Johnson privatized Fannie Mae in order to remove it from the national budget. At this point, Fannie Mae began operating as a GSE, generating profits for stock holders while enjoying the benefits of exemption from taxation and oversight as well as implied government backing. In order to prevent any further monopolization of the market, a second GSE known as Freddie Mac was created in 1970. Currently, Fannie Mae and Freddie Mac control about 90 percent of the nation's secondary mortgage market.
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FEDERAL HOME LOAN MORTGAGE CORPORATION ACT 
Approved July 24, 1970
As amended through July 21, 2010

It is the purpose of the Federal Home Loan Mortgage Corporation— 

(1) to provide stability in the secondary market for residential mortgages; 

(2) to respond appropriately to the private capital market; 

(3) to provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing; and 

(4) to promote access to mortgage credit throughout the Nation (including central cities, rural areas, and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing.
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"I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing"
-- Rep. Barney Frank, House Financial Services Committee hearing, Sept. 25, 2003

Mortgage Loan Reselling

Historically, most mortgage companies and banks serviced their mortgage loans after they originated them. Before making a loan, they took into account a potential borrower’s financial status and history, spending habits, and existing relationship with the lender, if there was one. Each lender had a great incentive to see that the mortgage was repaid in full and on time.

More recently, it has become common for loan originators to quickly resell their mortgage holdings to companies that specialize in servicing mortgage loans. In some cases, a mortgage loan is resold several times. Resold mortgages are often packaged into mortgage-backed securities (MBS).

The practice of reselling mortgages can foster a higher level of risk taking on the part of the lender, since the loan originator can be less concerned with the loan repayment, as they do not hold the loan very long. The repayment risk is passed on to the business servicing the loan after it is resold.

Also, about 90 percent of the mortgages written in the past few years are backed by the federal government — mainly through Fannie, Freddie or the Federal Housing Administration — which implies that some loan risk can be shifted to the government (in extreme cases).

The other 10 percent of mortgage loans are typically loans that are too large to be covered by government programs, or loans that the lenders decided to keep on their books for some other reason. Such lenders include community banks and credit unions — two types of institutions that have long embraced an old-fashioned, common-sense approach to mortgage lending.


Why the BIG reduction in home prices?
A price "bubble" starts with an exuberant rise from strong demand, which is then followed by an unplanned fall during weak demand.
For several years after 2000 the rise in U.S. home prices outpaced the historical norm, but in 2007 prices started to drop toward that norm.

U.S. House Price Index

Red dashed line is estimate of historical norm.

 

Why did the BIG reduction in home prices damage the U.S. economy so much?

Equity Losses Job Losses Leveraged Losses
A dramatic fall in home equity.

Perhaps the most defining aspect of the 2007 recession, and by many considered to be the origin of the financial crisis, has been the decline in the housing market.

An important consequence of the initial increase and subsequent fall in average house prices for households is the dramatic fall in home equity.

When home prices began to fall in 2007, owners’ equity in household real estate began to fall rapidly from almost $13.5 trillion in 1Q 2006 to a little under $5.3 trillion in 1Q 2009, a decline in total home equity of over 60%.

With the loss in home equity, a growing proportion of homeowners in fact lost all equity in their homes, finding the mortgage debt on their property to exceed its current market value.

Among homeowners with mortgages, at the end of 2009, 21% reported to be “underwater” at the time of the survey.
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Employment in the U.S. dropped in part due the loss of construction jobs, adding to the earlier loss of jobs in manufacturing.  

Shortly after home prices peaked in 2007, the number of new houses being built dropped dramatically. This resulted in a massive loss of construction jobs.


U.S. Housing Starts

This contraction in construction jobs was devastating when added to the already massive loss of manufacturing jobs that occurred shortly after 2000.


U.S. Manufacturing Jobs

 

A “post-securitization” credit crisis

The current crisis has the distinction of being the first “post-securitization” credit crisis, and so it has many unfamiliar features.


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Unlike the LTCM crisis of 1998 or the stock market crash of 1987, which bore the hallmarks of crises driven by a collapse of confidence, the current crisis has its roots in the credit losses of leveraged financial intermediaries. Liquidity injections by the central bank are an invitation to the financial intermediaries to expand their balance sheets by borrowing from the central bank for on-lending to other parties. However, a leveraged institution suffering a shortage of capital will be unwilling to take up such an invitation. Recognition of this reluctance is the key to understanding the protracted turmoil we have witnessed in the interbank market.

Mortgages and asset-backed securities built on mortgage assets are held in large quantities by leveraged institutions — by the broker-dealers themselves at the warehousing stage of the securitization process, by hedge funds specializing in mortgage securities, and by the off-balance-sheet vehicles that the banks had set up specifically for the purpose of carrying the mortgage securities and the collateralized debt obligations that have been written on them.

SIVs (structured investment vehicles) have played an important role in the current crisis. Conduits and SIVs were designed to hold mortgage-related assets funded by rolling over short-term liabilities such as asset-backed commercial paper (ABCP). However, during the initial stages of the crisis (roughly mid-August 2007), they began to experience difficulties in rolling over their ABCP liabilities. Many of the off-balance-sheet vehicles had been set up with back-up liquidity lines from commercial banks, and such liquidity lines were beginning to be tapped by mid-August.

As credit lines were tapped, the balance sheet constraint at the banks must have begun to bind, making them more reluctant to lend. In effect, the banks were “lending against their will.” The fact that bank balance sheets did not contract is indicative of this involuntary expansion of credit. One of the consequences of such an involuntary expansion was that banks sought other ways to curtail lending. Their natural response was to cut off, or curtail, lending that was discretionary. The seizing up of the interbank credit market can be seen as the conjunction of the desired contraction of balance sheets and the “involuntary” lending due to the tapping of credit lines by distressed entities.

Other factors, such as concerns over counterparty risk and the hoarding of liquidity in anticipation of new calls on the capital of the bank would certainly have exacerbated such trends. However, the hypothesis of an “involuntary” extension of credit appears important in explaining some of the salient features of recent credit market events.
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Financial markets perform the essential economic function of channeling funds to those who have productive investment opportunities (which can include consumer purchases of goods and houses). ...this function of financial markets is critical to a well-functioning economy; without it, countries, and their populations, cannot get rich. Enabling financial markets to effectively perform this essential function is by no means easy; financial markets must solve information problems to ensure that funds actually go to those with productive investments, so that they can pay back those who have lent to them. Financial development involves innovations or liberalization of financial markets that improve the flow of information. Unfortunately, however, financial liberalization and innovation, often have flaws and do not solve information problems as well as markets may have hoped they would. When these flaws become evident, financial markets sometimes seize up, often with very negative consequences for the economy.

...we have been experiencing exactly such a cycle in recent years. Advances in information and communications technology have allowed for faster and more disaggregated mortgage underwriting decisions. A mortgage broker with an Internet connection could quickly fill out an online form and price a loan for a customer with the help of credit-scoring technology. The same technological improvements would allow the resulting loan to be cheaply bundled with other mortgages to produce mortgage-backed securities, which could then be sold off to investors. Advances in financial engineering could take the securitization process even further by aggregating slices of mortgage-backed securities into more complicated structured products, such as collateralized debt obligations (CDOs), to tailor the credit risks of various types of assets to risk profiles desired by different kinds of investors.

As has been true of many financial innovations in the past, the benefits of this disaggregated originate-to-distribute model may have been obvious, but the problems less so. The originate-to-distribute model, unfortunately, created some severe incentive problems, which are referred to as principal-agent problems, or more simply as agency problems, in which the agent (the originator of the loans) did not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan). Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality. When loans went bad, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination. Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm. When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business. While the lending boom lasted, however, originators earned large profits.

Many securitizers of mortgage-backed securities and resecuritizers, such as CDO managers, also, in retrospect, appear to have been motivated more by issuance and arrangement fees and less by concern for the longer-run performance of these securities.
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Crisis Compels Economists To Reach for New Paradigm

The Leverage Cycle


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Why all the U.S. debt?
Watch this... Video 1, 2, 3, 4, 5, 6, 7, 8, 9

see... Money As Debt, II, III, IV


Federal Government Debt: Total Public Debt  source


U.S. Debt held by the public as a percentage of GPD   source


Follow the Money...

What in the world is going on?
Wealth is leaving the U.S.

1.) Dollars flow from U.S. to petroleum-exporting nations.

Public debt as a percent of GDP (2011) map source


Flows of Oil map source | petroleum exporter list


and

2.) Dollars flow from U.S. to merchandise-exporting nations.

Foreign currency reserves and gold minus external debt (2010) map source


Flow of Manufactured Goods (2004) map source | merchandise exporter list


and

What is going on in the U.S.?
Wealth is being transferred inside the U.S.

3.) Dollars flow into U.S. social welfare programs,
which were initiated as part of the New Deal resulting from
the
progressive movement (HooverRooseveltJohnson) and the so-called second Bill of Rights.

 Social Security Deficits 

Social Security Primary Surplus/Deficits (2005-2011)
source

 Medicare Deficits 
Medicare Surplus/Deficits
(Income minus Expenditures)
($s in Billions)

Medicare Surplus/Deficits (2005-2010)
source

 

What about the GDP?

 

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