“It is absolutely urgent and essential that we craft a comprehensive plan that materially reduces the deficit,” said Bennet. “But as this letter demonstrates, playing politics with the debt limit would rattle the capital markets, blow an even bigger hole in our deficit and would likely throw our economy into another deep recession. That is unacceptable, especially since Congress has the power to prevent it. We need a responsible and comprehensive approach to deficit reduction, not political games that put our country and our economy at risk.”

The Geithner Letter on Debt Limit )pdf) comes in response to a recently-penned letter by Bennet asking Treasury to spell out the economic and fiscal consequences of failing to raise the debt limit.

From The Wall Street Journal:

Some Republicans have questioned whether the Treasury would allow a default to occur, but Mr. Geithner said in the letter that “failure to raise the debt limit would force the U.S. to default on these obligations, such as payments to our service members, citizens, investors, and businesses.”

“This would be an unprecedented event in American history,” he wrote. “A default would inflict catastrophic, far-reaching damage on our Nation’s economy, significantly reducing growth, and increasing unemployment.”

Republicans leaders have said they want to raise the debt ceiling but only if the White House agrees to accompany its major spending cuts. House Speaker John Boehner (R., Ohio) has said it would be “irresponsible” to let the U.S. default, but “it would be more irresponsible to raise the debt ceiling without simultaneously taking dramatic steps to reduce spending and reform the budget process.”

Due to careful stewardship of the emergency programs, their effect on the deficit was much smaller than previously estimated. The Troubled Asset Relief Program (TARP) had outlays of just $9.0 billion in FY 2010, which was $25.9 billion or 74 percent below previous estimates from July 2010. Aid to Fannie Mae and Freddie Mac was $52.6 billion in FY 2010 — $16.4 billion or 24 percent less than the most recent forecast.

This played a large part in reducing the deficit, which as a percentage of gross domestic product (GDP) fell to 8.9 percent, down from 10.0 percent of GDP in FY 2009. This improvement — 1.1 percent of GDP — was the most rapid one-year improvement since FY 1987.

The takeaway: TARP worked and Fannie and Freddie did not need as much as the Treasury thought. Therefore, the deficit came in smaller than expected, at $1.294 trillion. That’s nine percent smaller and $122 billion less than last year.

But a smaller deficit is not necessarily a good thing — not during times of sustained, 9.6 percent unemployment. Democrats and most economists actually wanted a much bigger deficit, indicating massive government spending to juice the economy in the face of low aggregate demand. (Keynes, in simplified English: Because regular consumers aren’t buying things, employers are cutting payrolls. If the government buys things, employers will start hiring, meaning more consumers can buy more things, putting the economy back on track.)

The report shows that the government spent billions less on stimulus programs than it intended to, for a variety of reasons. Here are a few examples, comparing what the government actually spent with what it thought it would spend mid-year. (MSR stands for the Mid-Session Review of the FY 2011 Budget, which came out in July.)

• The MSR included an allowance for jobs initiatives, which reduced expected receipts by $1 billion. Delay in enactment of a job creation package increased FY 2010 receipts $1 billion relative to the MSR.
• Actual outlays for the Supplemental Nutrition Assistance Program were $2.1 billion lower than MSR estimates. Outlays for the Special Supplemental Nutrition Program for Women, Infants, and Children (WIC) were also lower by roughly $1.2 billion, as actual WIC participation and food costs were lower than expected.
• Outlays for the Department of Commerce were $13.2 billion, $2.7 billion less than the MSR estimate. Three-fifths of the difference is due to favorable performance of the 2010 Decennial Census, including higher-than-expected workforce productivity and a higher-than-expected Census questionnaire mail-back response rate that reduced the need for costly non-response follow-up operations, resulting in no need to tap contingency funds set aside for disasters or major operational failures.
• Outlays for the Department of Labor were $172.9 billion in FY 2010, $7.8 billion less than the MSR estimate. Most of the difference was due to lower-than-expected spending on unemployment compensation benefits, including Emergency Unemployment Compensation.
• Outlays for the Department of Transportation were $77.8 billion, $7.7 billion lower than projected in the MSR. The surface transportation programs, which were $6.0 billion below MSR projections, were affected by uncertainty due to numerous short-term program authorization extensions. The largest difference was in the Federal Highway Administration, where Federal Aid Highway program outlays were $4.4 billion below the MSR projection. In addition, Federal Transit Administration program outlays were $1.4 billion below expected levels. For these two programs, short-term authorizations limited States’ ability to obligate funds in a timely manner.
• Outlays for the Child Tax Credit and Making Work Pay Credit were below MSR estimates by $1.8 billion and $2.4 billion, respectively, as the state of the economy generally reduced taxpayers’ eligibility for these credits. These below-MSR outlays were partially offset by COBRA program outlays nearly $3.1 billion above the MSR estimate.

A foreclosed home in Winchester, Va. (Jay Mallin/ZUMA Press)

Yesterday, Wall Street giant J.P. Morgan Chase announced a $4.4 billion profit in the third quarter. Wall Street analysts should have cheered. Instead, they golf-clapped, while the bank’s chief executive officer, Jamie Dimon, went on the defensive on an earnings call.

[Economy1] The reason: foreclosures, again threatening everything from homeowners’ security to banks’ bottom lines. In early September, an employee of GMAC Mortgage admitted he had signed as many as 10,000 affidavits, required in 23 states to proceed with foreclosure, a month. The affidavits attested that the employee had personal knowledge of homeowners’ financials before the bank foreclosed. Given that he obviously did not, the paperwork might have constituted fraud and the foreclosures were possibly illegal.

The scandal went big, embroiling mortgage-holding banks like J.P. Morgan Chase in a problem of possibly systemic proportions. Stories of banks lacking required title documentation and evicting the wrong families from homes flooded into the press. Financial companies, including J.P. Morgan Chase, halted foreclosures in the states that require judicial review, and then some halted them everywhere. Members of Congress announced hearings. Finally, yesterday, all 50 state attorneys general announced a probe into systemic problems with mortgage documentation.

On the J.P. Morgan Chase earnings call, Dimon promised that there was “almost no chance we made a mistake” with foreclosures. “We think we should continue and get done and make sure we do the right things for the consumers, the investors and the country. So it obviously will increase our cost a little bit and maybe we’ll have to pay penalties eventually to some of the attorneys general but we really think we should just continue.”

But the financial statement itself proved the lie. The bank said it was carefully checking 115,000 mortgage affidavits. It set aside a whopping $1.3 billion for legal costs. And it put an extra $1 billion into a now $3 billion fund for buying back bunk mortgages and mortgage products.

For banks like J.P. Morgan Chase, the issue is not just the legal headaches. It is the financial blowback. The mortgage-documentation scandal, housing experts warn, runs far and deep — involving not just foreclosure papers, but titles and rights and fiduciary contracts. And it has analysts on Wall Street and politicians on the Hill wondering whether the worst-case scenario might involve not just losses, but bank failures or government bailouts.

The pending mortgage problems resemble those that caused the failure of Lehman Brothers, the credit crunch and the ensuing financial crisis in October 2008: Every bank has problematic mortgage holdings on its books, and each bank is interconnected with every other. Before the bubble burst, investment banks bought up faulty mortgages, many of them subprime loans, from lending banks. Investment banks then bundled the mortgages into mortgage-backed securities, for sale to investors. But just as banks are now foreclosing without proper documentation, they were bundling mortgages without proper documentation — abdicating their fiduciary responsibility to investors and muddying the waters as to who actually owns the loans.

That means the investors who own mortgage-backed securities might argue that the products do not meet the contract standards. If those investors choose to sue the originating investment banks en masse, for breach of contract, they would force the banks to buy back the rotten mortgage-backed securities. That would cost in the hundreds of billions — swamping banks’ profits and sweeping away any cash they might be keeping on hand.

At least one mortgage analyst, Josh Rosner, a managing director at Graham Fisher & Co., has said that if investors force banks to take back the $1.3 trillion of mortgage-backed securities in question, it could create a kind of doomsday scenario pitching the markets back into crisis. Indeed, Rosner believes it could feel very much like 2008 again.

“This is poetic justice,” says Janet Tavakoli, of Tavakoli Structured Finance in Chicago. “The mortgages that seem to be most affected are by predatory lenders, or lenders who engaged in fraudulent practices, like appraising a home for twice its value. The careless investment banks were willing to overlook that fraud. But they just bred fraud into their mortgage-backed securities.”

She does not believe every bank will have face write-downs due to mortgage buy-backs. But she does believe the losses might be substantial. “It’s not clear to me that every mortgage has this problem,” she says. “But there’s no transparency on this issue now. And it is clear that we are dealing with massive, systemic fraud.”

One way or another, some on the Hill are bracing for the worst.

“[Banks will] have to buy back one mortgage at a time,” Rep. Brad Miller (D-N.C.) told The Washington Post. “Someone said there might be a second round of bank insolvencies because of this and there might need to be more TARP. There is no chance that Congress would pass more TARP. It’s hard even to see how it ends. But I’ve got to think it creates more uncertainty about the health of the banks.”

Rep. Alan Grayson (D-Fla.) has gone further, proactively asking the Financial Stability Oversight Council — created by the Dodd-Frank financial regulatory reform law — to step in to stop foreclosures and monitor the banks, just in case.

“There are now trillions of dollars of securitizations of these loans in the hands of investors,” Grayson wrote in a letter (PDF) to the Council, which includes Treasury Secretary Timothy Geithner and Federal Deposit Insurance Corp. Chair Sheila Bair. “The trusts holding these loans are in a legal gray area, as the mortgage titles were never officially transferred to the trusts. The result of this is foreclosure fraud on a massive scale, including foreclosures on people without mortgages or who are on time with their payments. The liability here for the major banks is potentially enormous, and can lead to a systemic risk.”

And it seems the banks — if not J.P. Morgan Chase — are also acknowledging that risk. Josh Levin, an analyst with Citigroup Global Markets, described three potential outcomes to investors, citing work by Georgetown law professor Adam Levitin. The first is that courts consider the erroneous foreclosures technicalities, and the losses are minimal. The second is that banks face significant legislation, but ultimately aren’t forced to buy back mortgage-backed securities.

And the third? “In the worst-case scenario,” he said, “the aforementioned issues become a ‘systemic problem’ which causes the mortgage market to grind to a halt.”

Treasury Secretary Timothy Geithner and Transportation Secretary Ray LaHood flanked the president — as did a bevy of mayors; Norman Mineta, a Democrat and George W. Bush’s transportation secretary; and Samuel Skinner, a Republican and George H.W. Bush’s transportation secretary.

“By making these investments across the country, we won’t just make our economy run better over the long haul,” the president argued, repeating a push he first made on Labor Day. “We’ll create good, middle-class jobs right now.” To back him up, the Council of Economic Advisers released (PDF) a new analysis of the White House’s $50 billion proposal, tied to a re-authorization of the surface transportation program and the creation of a new National Infrastructure Bank.

The public broadly supports such infrastructure spending. From the CEA report:

As a result of years of under-investment in our transportation system, Americans’ satisfaction with our public transit system, when compared to public satisfaction with public transit systems around the world, ranks 25th out of 32 OECD nations. While our nation has historically favored road building over public transit, we rank only 17th out of 32 — in the middle of the pack — with respect to our satisfaction with our roads and highways. The relatively higher satisfaction with roads and highways is consistent with the observation that our nation’s historic investment pattern favored highways and roads over public transit.

One study found that almost 19 out of 20 Americans are concerned about America’s infrastructure and 84 percent support greater investment to address infrastructure problems.

But Congress has proved intransigent. Republicans have repeatedly blocked any additional stimulus spending, no matter how many jobs it might create, citing concerns over the deficit. And Obama cannot create new investment — no matter how economically rational — without Congress.

Nevertheless, he points to very real and very significant signs of a turnaround:

• Exports are booming because American companies are very competitive and lead the world in many high-tech industries.
• Private job growth has returned — not as fast as we would like, but at an earlier stage of this recovery than in the last two recoveries. Manufacturing has generated 136,000 new jobs in the past six months.
• Businesses have repaired their balance sheets and are now in a strong financial position to reinvest and grow.
• American families are saving more, paying down their debt and borrowing more responsibly. This has been a necessary adjustment because the borrow-and-spend path we were on wasn’t sustainable.
• The auto industry is coming back, and the Big Three — Chrysler, Ford and General Motors — are now leaner, generating profits despite lower annual sales.
• Major banks, forced by the stress tests to raise capital and open their books, are stronger and more competitive. Now, as businesses expand again, our banks are better positioned to finance growth.
• The government’s investment in banks has already earned more than $20 billion in profits for taxpayers, and the TARP program will be out of business earlier than expected — and costing nearly a quarter of a trillion dollars less than projected last year.

What will really turn things around? Jobs. At some point, private employers, now hoarding cash with their profits, will return to picking up employees. That means Americans will be able to spend more, and the cycle will become virtuous again.

It’s hard to blame them. Reforming Fannie and Freddie might prove as complicated as reforming Wall Street. The two government-sponsored enterprises are currently backing around nine in ten new mortgages, propping up a weak housing market at a cost of hundreds of billions to taxpayers. Housing experts worry acting too rashly could crater the tentative housing recovery, but also note that the government, at some point, needs to re-regulate mortgage finance, reform Fannie and Freddie and let the private market take over.

Back in April, the Treasury Department released a list of seven questions to this end, asking for experts to submit ideas for reform. Last week, Rep. Barney Frank (D-Mass.) said he will start work on a housing finance bill this fall. And today, the Obama administration announced it will hold a conference on Aug. 17, bringing together community groups, consumer advocates, housing industry figures and economists to contemplate how to fix the multi-trillion dollar market. In its announcement on the Conference on the Future of Housing Finance, the administration said it will have a housing finance reform bill ready by January — the first concrete date it has set, to my knowledge at least.

“The future of our housing finance system is critical not only to our economic recovery, but also to millions of American homeowners in every corner of our country,” Treasury Secretary Tim Geithner said in the press release. “Now is the time to build on the foundation we laid with the historic Wall Street Reform legislation President Obama signed last week and aggressively move forward to improve our nation’s housing finance system. The Obama administration is committed to delivering a comprehensive reform proposal that protects taxpayers, institutes tough oversight, restores the long-term health of our housing market, and strengthens our nation’s economic recovery.”

[T]hose who advocate a monetary helicopter-drop of money to stimulate growth concede that the Fed doesn’t have the capacity to do it without some action by Treasury to distribute the funds, which would be fiscal in nature. It would also require congressional action that is very unlikely in the current political environment.

That basically leaves two things that the Fed can do: buy longer term securities and buy very unconventional assets such foreign currency denominated bonds. The first it has already done some of without doing much to get money circulating. The second would put the Fed at war with the Treasury, which jealously guards its dominion over exchange rate policy.

Matt Yglesias counters that this is wrong:

[Treasury Secretary] Timothy Geithner has already received appropriations to buy printer paper and toner cartridges for the Treasury Department. If [Federal Reserve Chairman] Ben Bernanke is inclined to play along, there’s no bar stopping Geithner from literally firing up his word processor program and printing out pieces of paper that say “Take this to Ben Bernanke and he’ll give you $10,000.” [...]

But the larger point I would make is that focusing on the precise microdynamics of Fed action is a mistake. What’s more important is how the Fed frames what it’s doing. If the Fed says it’s determined to push the price level up, and will keep trying things until it gets up to such-and-such a point then that will probably work.

The latter point, I think, is the right context in which to view Bernanke’s testimony to Congress from last week. Bernanke might think the economy needs more stimulus, and almost certainly thinks the best way for that to happen is for Congress to authorize additional stimulus spending — jobs programs, public works projects, additional Supplemental Nutrition Assistance Program funding, state aid, expanding the unemployment insurance system, what have you — since interest rates have nowhere to fall.

He could have attempted to convince Congress to do that. He could have warned about the peril of rising unemployment leading to a double dip. He could have said, “Absent additional congressional action, the Federal Reserve, in accordance with its mandate to encourage full employment, will attempt to push up price levels using x and y methods.”

Instead, he opened his remarks stating, “The economic expansion that began in the middle of last year is proceeding at a moderate pace, supported by stimulative monetary and fiscal policies. Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth.”

Again, convincing Congress to do something and publicly contradicting any rosy reports out of Treasury would be the obvious first way to go. This implies to me that, rightly or wrongly, Bernanke does not think the economy needs more stimulus.

But Republicans and some centrist Democrats are also in agreement: Rising taxes gives families less money to spend, and that means a slower recovery. “I think given the fragility of the recovery, the timing is wrong for any kind of tax increase of this nature,” Rep. Gerry Connolly (D-Va.) told The Wall Street Journal. “I know that puts me out of step with many in my own caucus, but it’s important for members to remember the top 5 percent [of earners] generates 30 percent of consumer spending.”

Importantly, Sen. Kent Conrad (D-N.D.), the chair of the Senate Budget Committee, has said he does not support tax increases on any workers, yet. “As a general rule, you don’t want to be cutting spending or raising taxes in the midst of a downturn,” he says. “At the same time, we know that very soon we’ve got to pivot and focus on the deficit,” he said. “But it probably is too soon to cut spending or raise taxes.”

To get a bill over the Senate’s 60-vote cloture hurdle, therefore, Democrats might extend the totality of the cuts for two years, and include a long-term plan to raise taxes on wealthy Americans, perhaps followed by other income bands far down the road. The Bush tax cuts cost the government over $1 trillion in revenue. And economists argue that tax cuts have a wan stimulative effect in comparison with expanding the unemployment insurance system or programs like the Supplementary Nutrition Assistance Program, or SNAP benefits, formerly known as food stamps.

The discussion kicked off after the final passage of the Dodd-Frank financial regulatory reform bill, which will become law when President Obama signs it tomorrow. And it heated up when a Huffington Post story, citing unnamed sources and pushed back on by the White House, said that Treasury Secretary Timothy Geithner opposes the much-lauded Warren — a Harvard Law professor, expert on consumer finance and the current head of the Congressional Oversight Panel over the Troubled Asset Relief Program. (The idea for the CFPB is hers, to boot.)

Since then, the White House and legislators have rushed to offer praise, if not outright support, for her. Rep. Carolyn Maloney (D-N.Y.) circulated a letter asking legislators to get behind her. Dozens did so. And the White House signaled its possible support too. “While there are a number of strong choices under consideration for this position, Elizabeth Warren is a champion for consumers and middle-class families, and we are confident she is confirmable,” Jen Psaki, a White House spokesperson, said.

At The Washington Post, Brady Dennis confirms that Warren is a short-list candidate, along with Assistant Treasury Secretary Michael Barr and Eugene Kimmelman, a deputy attorney general and former consumer advocate. (The White House will name the head of the CFPB, and Congress has to confirm him or her.) And WaPo’s Neil Irwin details the concern that she does not have the executive experience necessary to run a bureaucracy.

Still, her advocates are coalescing on the left. Yesterday, Americans for Financial Reform endorsed her. Today, the SEIU and the AFL-CIO, the powerful labor unions, also threw their weight behind her. Of course, the question will be whether she can draw a Republican or two to vote for confirmation in the Senate. Thus far, none have come out publicly in support.

Warren is “obviously a candidate to lead this effort,” Axelrod said on a call with reporters this afternoon, “but there are other candidates as well.”

The top Obama adviser described Warren, currently the chair of the Congressional Oversight Panel for the bailout funds, as a “great, great champion for consumers and middle class families across the nation.”

Treasury Secretary Timothy Geithner reportedly opposes Warren for the position.

Axelrod called the financial reform legislation “a huge leap forward for consumers,” and he criticized House Minority Leader John Boehner’s (R-Ohio) “stunning” call for repeal of the legislation.

“I was surprised yesterday, frankly, that even as this bill was being passed the Republican leader in the House was announcing his mission to repeal it, if they get the opportunity to do so,” he said, invoking Boehner’s claim that the bill was akin to “killing an ant with a nuclear weapon.”

“I think that tells you exactly what side of this argument they’re on,” Axelrod said.