Bill Totten's Weblog

Sunday, August 10, 2008

Debt capitalism self-destructs

by Henry C K Liu

Asia Times Online (July 22 2008)

In a period of less than a year, what had been described by US authorities as a temporary financial problem related to the bursting the housing bubble has turned into a fully fledged crisis at the very core of free-market capitalism.

A handful of analysts have been warning for years that the wholesale deregulation of financial markets and the wrong-headed privatization of the public sector during the past two decades would threaten the viability of free-market capitalism. Yet ideological neoliberal fixation remain firmly imbedded in US ruling circles, fertilized by irresistible campaign contributions from profiteers on Wall Street, methodically purging regulatory agencies of all who tried to maintain a sense of financial reality.

This ideology of "market knows best" has allowed the nation to slip into an unsustainable joyride on massive debt giddily assumed by all market participants, ranging from supposedly conservative banks, investment banks and other non-bank financial institutions, to industrial corporations, government sponsored enterprises (GSEs) and individuals.

The once-dynamic US economy has turned itself into a system in which it is difficult to find any institution, company or individual not over their head in speculative debt. Undercapitalized capitalism, also known as debt capitalism, has been the engine of growth for the US debt bubble in the last two decades. This debt capitalism cancer is caused by a failure of central banking.

In the face of a broad systemic collapse of debt capitalism, where capital has become dangerously inadequate and new capital hazardously and prohibitively scarce, having been crowded out by massive debt collateralized by overblown assets of declining value and with a credit crisis that clearly requires systemic restructuring and comprehensive intensive care, those in the US responsible for the financial well-being of the nation seem to have been reacting tactically from crisis to crisis with a script of adamant denial of obvious facts, symptoms and trends, with no signs of any coherent grand strategy or plan to save the cancerous system from structural self-destruction.

This band-aid short-term approach to artificially pop up share prices in the collapsing equity market and to maintain insolvent financial institutions with technical life-support will lead only to long-term disaster for the whole economy.

Yet this approach is preferred by those in authority, trapped in self deception about unregulated market capitalism being still fundamentally sound. They try to calm markets by asserting that the current turmoil is merely a minor liquidity bottleneck that can be handled by the central bank releasing more liquidity against the full face value of collaterals of declining worth.

The message is that somehow, if easy money in the form of debt is made endlessly available, the economy will recover from this credit crunch, notwithstanding that excessive debt has been the cause of the problem; or bad loans can be made good by Congress giving the US Treasury authority to buy up bad loans with unlimited amounts of taxpayer money.

Yet these incremental measures taken so far by the Treasury and the Federal Reserve make the two government units with direct responsibility on the nation's long-term financial health look like panicky rogue traders trading for the national account in desperate hope to score a win in the next quarter by upping the ante, to contain allegedly isolated crisis hot points. The aggregate effect adds up to a broad stealth nationalization of the insolvent financial sector. Their prescription for stabilizing a debt-destabilized market is more public debt to support corporation socialism.

For years, anyone warning that the government sponsored enterprises (GSEs), namely Fannie Mae and Freddie Mac, should be held to normal capitalization requirements was ridiculed as a fear monger by the powerful lobbying machines these GSEs employed. Capital is considered as superfluous in the new game of debt capitalism held up by complex circular hedging. As a result, the GSEs have become the monstrous tail that wags the dog of housing finance.

The current talk about the need to curb speculation in the commodities and financial markets to stabilize prices is off target, especially for believers of market capitalism. All market transactions are speculative in nature. Speculation can stabilize prices as well as to destabilize them, but only in the short term. Long-term price levels (inflation or deflation), as Milton Friedman aptly observed, are always monetary phenomena. The current turmoil in the financial system, the subprime mortgage implosion, the credit crisis from the seizure in the asset-backed commercial papers market, the undercapitalization of commercial and investment bank, the rating agency dysfunction, the insolvency of monocline (bond) insurers, the massive financial losses by the GSEs and a host of other financial problems percolating under the media radar, are the outcome, and not the cause, of this market turbulence. (See Perils of the debt-propelled economy, Asia Times Online, September 14 2002.)

Fanny Mae and Freddy Mac, GSEs that have provided mortgage funds for the housing market since 1938, were created as part of the New Deal to help low-income families. They were privatized in 1968 on terms that would alter their social mandate and would inevitably lead them into financial trouble on a big scale. Finally but suddenly, these GSEs find themselves in danger of defaulting on their massive debts, upwards of US$5 trillion, in the course of a single week.

Deeply rooted in US political culture is the view that credit is a financial public utility, much like air and water, and should be equally accessible to all, not just to the rich. Economic democracy has been the core strength of US political democracy. Government loan guarantees for students and home mortgages for low- and moderate-income groups and loans to small business are based on this principle. Yet from time to time, this principle of economic democracy is overshadowed by free-market extremism to push the nation's economy into extended depressions.

The US National Housing Act was enacted on June 27 1934, as one of several economic recovery measures of the New Deal to get the nation out of the Great Depression. It provided for the establishment of a Federal Housing Administration (FHA). Title II of the Act provided for the insurance of home-mortgage loans made by private lenders, taking the disaggregated risk in lending to low-income borrowers off private lenders and managing the risk on a national scale with a government agency to take advantage of the law of large numbers, a theorem in probability that describes the long-term stability of a random variable. Title III of the Act provided for the chartering of national mortgage associations by the FHA administrator. These associations were to be independent corporations regulated by the administrator, and their chief purpose was to buy and sell the mortgages insured by the FHA under Title II.

Only one association was ever formed under this authority. On February 10 1938, this association, the National Mortgage Association of Washington, became a subsidiary of the Reconstruction Finance Corp, a government corporation. Its name was changed that same year to Federal National Mortgage Association (Fannie Mae). By amendments made in 1948, Title III of the US National Housing Act became a statutory charter for Fannie Mae.

Balloon payment barrier

Before the Great Depression, affording a home was difficult for most people in the US. At that time, a prospective homeowner had to make a down payment of forty percent and pay the mortgage off in three to five years. Until the last payment, borrowers paid only interest on the loan. The entire principal was paid in one lump sum as the final "balloon" payment. Lenders could demand full payment of the outstanding loan at any time of the lender's choosing, often at time least advantageous to borrowers. This allowed lenders to use foreclosures as a means to take over desirable properties.

During the 1920s boom time in real estate, a rudimentary secondary mortgage market had come into being. The stock-market crash of 1929 ended the real-estate boom and forced many private guarantee companies into insolvency as home prices collapsed. As economic conditions worsened, more and more borrowers defaulted on mortgages because they couldn't come up with the money for the final balloon payment or to roll over their mortgage because of low market value of their homes.

To help lift the country out of the Great Depression, Congress created the FHA through the National Housing Act of 1934. The FHA's insurance program protected mortgage lenders from the risk of default on long-term, fixed-rate mortgages. Because this type of mortgage was unpopular with private lenders and investors, Congress in 1938 created Fannie Mae to refinance FHA-insured mortgages.

As soldiers came home from World War II, Congress passed the Serviceman's Readjustment Act of 1944, which gave the Department of Veterans Affairs (VA) authority to guarantee veterans' loans with no down payment or insurance premium requirements. Many financial institutions considered this arrangement a more attractive investment than war bonds.

By revision of Title III in 1954, Fannie Mae was converted into a mixed-ownership corporation, its preferred stock to be held by the government and its common stock to be privately held. It was at this time that Section 312 was first enacted, giving Title III the short title of Federal National Mortgage Association Charter Act.

By amendments made in 1968, the Federal National Mortgage Association was partitioned into two separate entities, one to be known as the Government National Mortgage Association (Ginnie Mae), the other to retain the name Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in the government, and Fannie Mae became privately owned by retiring the government-held stock. Ginnie Mae has operated as a wholly owned government association since the 1968 amendments. Fannie Mae, as a private company operating with private capital on a self-sustaining basis, expanded to buy mortgages beyond traditional government loan limits, reaching out to a broader income cross-section.

By the early 1970s, inflation and interest rates rose drastically. Many investors drifted away from mortgages. Ginnie Mae eased economic tension by issuing its first mortgage-backed security (MBS) guarantee in 1970. Investors found these guaranteed MBSs highly attractive. Also in 1970, under the Emergency Home Finance Act, Congress chartered the Federal Home Loan Mortgage Corp (Freddie Mac) to buy conventional mortgages from federally insured financial institutions. The legislation also authorized Fannie Mae to purchase conventional mortgages. Freddie Mac introduced its own MBS program in 1971.

Fannie and Freddie charters give these GSEs exemptions from state and local taxes, allow them relatively meager capital requirements, and provide them with an ability to borrow money at lowest possible rates to lend at near market rates. Over the years, this advantage has served not to lower home prices and mortgage payments to help low-income buyers but to enrich debt securitizers and brokers.

Aging credit line

Each agency now has a $2.25 billion credit line with the Treasury, set nearly forty years ago by Congress at a time when Fannie had only about $15 billion in outstanding debt. It now has total debt of about $800 billion, while Freddie has about $740 billion. Today the two companies also hold or guarantee loans with face value of more than $5 trillion, about half the nation's mortgages. Market analysts estimate that the market value of this liability may be less than fifty percent unless the housing market recovers. In other words, the GSEs face a $3.5 trillion exposure to default if they cannot raise new funds in the credit market.

In the early 1980s, the US economy spiraled into deep recession. Interest rates were high while house prices while falling, remaining beyond the reach of many low- and moderate-income buyers because income growth stayed stagnant. The US economy faced a dual problem of income deficiency and money devaluation. In this poor housing market environment, Ginnie Mae, Fannie Mae and Freddie Mac all created programs to handle adjustable-rate mortgages. The Ginnie Mae guaranty is backed by the full faith and credit of the United States. Today, Ginnie Mae guaranteed securities are one of the most widely held and traded MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion in MBSs. Historically, 95% of all FHA and VA mortgages have been securitized through Ginnie Mae. Ginnie Mae is a guarantor, a surety. Ginnie Mae does not issue, sell, or buy MBSs, or purchase mortgage loans. Ginnie Mae is not in financial distress.

Fannie Mae is another story. Many of the innovative mortgage options introduced during the early 1980s to revive the weak housing market in a recession were exploited to fuel a housing bubble with excessive liquidity provided by the Federal Reserve, helping low- and middle-income buyer to buy homes their stagnant income could not afford. Fannie continues to operate under a congressional charter that directs it to channel its efforts into increasing the availability and affordability of home ownership for low-, moderate- and middle-income Americans. Yet Fannie Mae receives no government funding or backing, and it is one of the nation's largest taxpayers as well as one of the most consistently profitable corporations until now.

The company has evolved to become a shareholder-owned, privately managed corporation supporting the secondary market for conventional loans. Its congressional mandate of keeping homes affordable has since been largely forgotten in favor of an unprecedented boom in the housing market. Yet it continues to operate under a congressional charter that provides it with low-cost funds with only perfunctory oversight from the US Department of Housing and Urban Development and the US Treasury.

Fannie Mae has two primary lines of business: Portfolio investment, in which the company buys mortgages and mortgage-backed securities (MBSs) as investments, funding those purchases with debt, and credit guaranty, which involves guaranteeing for a fee the credit performance of single-family and multi-family loans.

Overseas debt holders

During the housing bubble which it essentially helped create with the Fed easy money, Fannie was highly profitable, with high returns for happy shareholders and lucrative compensation for its executives. Above all, it provided a continuous stream of income and profit for Wall Street and central banks around the world while US homeowners were led down a treachery path of eventual foreclosure. According to data from the Council on Foreign Relations, foreign central banks own $925 billion of debt in the two GSEs. China tops the list with $420 billion in Freddie and Fannie debt; Russia and Japan come in second with a combined $407 billion in GSE debt. Others countries that hold the debt include Singapore, Taiwan, and several cash-rich countries in the Persian Gulf.

Fannie's portfolio investment business includes mortgage loans purchased throughout the US from approved mortgage lending institutions. It also purchases MBSs, structured mortgage products and other assets in the open market. The corporation derives income from the difference between the yield on these investments and the low subsidized costs to fund the purchase of these investments, usually from issuing debt in the domestic and international markets. Fannie Mae has $3.46 trillion in MBSs outstanding today, held by a dispersed network of investors, including foreign central banks, topped by China's.

The GSEs now only pay lip service to accomplishing its mission to provide products and services that increase the availability and the affordability of housing for low-, moderate- and middle-income buyers by operating in the secondary rather than the primary mortgage market.

Fannie Mae purchases mortgage loans from mortgage lenders such as mortgage companies, savings institutions, credit unions and commercial banks, thereby replenishing those institutions' supply of mortgage funds. It either packages these loans into MBSs, which it guarantees for full and timely payment of principal and interest, or purchases these loans for cash and retains the mortgages in its own portfolio. Yet Fannie's role in recent years has been to supply the housing bubble with excess liquidity released by a wayward central bank, by buying at a profit economically unsound mortgages that depended on a continuing spiral of rising home prices way beyond reasonable projection of home buyer income growth. It has turned the US from a nation of homeowners into a nation of foreclosed homes.

Fannie Mae is now one of the world's largest issuers of debt securities, the leader in the $14 trillion US home-mortgage market. Fannie Mae's debt obligations are treated as US agency securities in the marketplace, which is just below US Treasuries and above AAA corporate debt. This agency status is due in part to the creation and existence of the corporation pursuant to a federal law, the public mission that it allegedly serves, and the corporation's continuing ties to the US government through a weak oversight link. It benefits from an appearance, though not the essence, of being backed by sovereign credit that borders on outright fraud and protected by the doctrine of too big to fail.

Fannie Mae debt obligations receive favorable treatment from a regulatory perspective. Fannie Mae securities are "exempted securities" under laws administered by the US Securities and Exchange Commission to the same extent as US government obligations. Also, Fannie Mae debt qualifies for more liberal treatment than corporate debt under US federal statutes and regulations and, to a limited extent, foreign overseas statutes and regulations. Fund managers who buy GSE debt are protected from fiduciary challenges.

Some of these statutes and regulations make it possible for deposit-taking institutions to invest in Fannie Mae debt more liberally than in corporate debt and other mortgage-backed and asset-backed securities. Others enable certain institutions to invest in Fannie Mae debt on par with obligations of the United States and in unlimited amounts. Fannie Mae uses a variety of funding vehicles to provide investors with debt securities that meet their investment, trading, hedging, and financing objectives, not all of which serves the public interest. Fannie Mae is able to issue different debt structures at various points on the yield curve because of its large and consistent funding needs. As the Treasury retired thirty-year bonds, these GSE agencies stepped in to fill the void in long term finance.

Ideology triumphant

The privatization of Fannie Mae and Freddie Mac was an ideological move. It was financially unnecessary as sovereign credit could have funded the entire low-, moderate- and middle-income housing-mortgage needs with no profit siphoned off to private investors and brokers. These agency debt instruments played a crucial role in developing and sustaining the credit bubble in the US that is now coming home to roost.

In fact, the funding risk of both agencies was questioned, among many others, by the voice of free-market capitalism, the Wall Street Journal, on February 20 2002 in an editorial about Fannie Mae's and Freddie Mac's safety, soundness and financial management, characterizing both agencies as risky, fast-growing companies that "look like poorly run hedge funds" ... "unduly exposed to credit risk with large derivative positions", and that they "use all manner of derivatives" and "are exposed to unquantified counterparty risk on these positions". Such concerns would have been avoided if both agencies had been funded directly with government credit, and the cost of housing to low-, moderate- and middle-income Americans would have been lower. As it happens, the government is now faced with the prospect of having to bail out these GSEs with public funds.

The term "undercapitalization" for financial institutions is merely a sanitized euphemism for insolvency. The real source of the present market turbulence is more than just the waywardness of runaway GSEs sidetracked from their public purpose. It is another symptom of the failure of central banking. The world is now witnessing the slow but steady collapse of the central banking regime that came into being in the US in 1913, which has since failed to fulfill its mandate of managing the monetary system to maintain price stability and full employment. Dysfunctional monetary policies adopted by all central banks, led by the US Federal Reserve, have allowed the market to take capital out of free market capitalism to turn it into a gigantic Ponzi scheme.

In the 1990s, the original congressional intent for the GSEs was distorted from making homeownership affordable to low- and moderate-income families to a new role of supporting a housing bubble that enables families to buy homes at prices with mortgages their incomes cannot service. The profit from housing price appreciation went mostly to mortgage originators and banks that bought and sold MBSs to investors who also profited from buying debt with debt collateralized with the debt they bought. Capital suddenly became only a notional value in the market of debt derivatives. Homebuyers bought mortgages with no down payment, banks and mortgage brokers sold the debt to securitizers who sold it to institutional investors who borrowed using the securities as collateral. The GSEs also became very profitable, leaving homeowners to default on their mortgages as the market turned on them. The whole transaction cycle did not require any capital.

Fannie Mae and Freddie Mac, ranked Aaa by the world's leading credit-rating companies, are now being treated by derivatives traders as if they were rated five levels lower because the issuers are pitifully undercapitalized for the size of the debt they issue. Credit-default swaps tied to $1.45 trillion of debt sold by these two biggest allegedly US-backed mortgage finance companies are trading at levels that imply the bonds should be rated A2 by Moody's Investors Service. The price of contracts used to speculate on the creditworthiness of Fannie Mae and Freddie Mac and to protect against a default has doubled in the past two months.

Debt guarantee disregarded

Traders are disregarding the government's implied guarantee of GSE debt as credit losses grow and concern rises about the GSEs not having enough capital to weather the biggest housing slump since the Great Depression. Fannie Mae has lost eighty percent of market capitalization value in the first half of 2008 on the New York Stock Exchange; and Freddie Mac lost seventy percent. The two GSEs reported combined operating losses of more than $11 billion, and have raised more than $20 billion new capital since December 2007. After Lehman Brothers Holdings Inc released a report on June 7 2008, saying a new accounting rule may require the GSEs to raise another $75 billion in new capital, Freddie Mac shares dropped another eighteen percent and Fannie Mae fell sixteen percent.

Still, the Office of Federal Housing Enterprise Oversight (OFHEO), the regulator of these GSEs, declared them as adequately capitalized in regulatory terms. The companies' existing congressional charters give the Treasury the authority to buy as much as $2.25 billion in each of their securities in the event of possible default, against a total liability of over $5 trillion. The works out as an equity injection of less than half-a-cent on each dollar of liability.

Credit-default swaps tied to the senior debt of Fannie Mae and Freddie Mac have climbed 35 basis points to seventy basis points since May 1 2008. A basis point is 0.01 percentage point. The cost to protect the companies' subordinated debt from default rose at a faster rate. That debt is rated Aa2 by Moody's. Credit-default swaps on Fannie Mae's subordinated notes jumped 103 basis points to 190 basis points since May 1, while contracts on Freddie Mac's subordinated notes rose 102 basis points to 190 basis points.

The median credit-default swap on debt rated Aaa by Moody's was 26 basis points as of July 8. It was 76 basis points for debt rated A2, and 180 basis points for debt rated Baa3, the lowest investment-grade ranking. The costs likely reflect counterparty risk, or the risk that the bank or securities firm on the other end of the contract fails. For most companies, the counterparty risk embedded in credit-default swap costs would not be as pronounced because the risk of a default on the underlying debt would be greater than that of the bank backing the protection. In the case of Fannie Mae, Freddie Mac and other companies with Aaa ratings, the default risk for lower-rated banks is greater.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite. A basis point on a contract protecting $10 million of debt for five years is equivalent to $1,000 a year.

On January 11 2006, in Asia Times Online I wrote in Of debt, deflation and rotten apples:

"In the US, where loan securitization is widespread, banks are tempted to push risky loans by passing on the long-term risk to non-bank investors through debt securitization. Credit-default swaps, a relatively novel form of derivative contract, allow investors to hedge against securitized mortgage pools. This type of contract, known as asset-back securities, has been limited to the corporate bond market, conventional home mortgages, and auto and credit-card loans. Last June [2005], a new standard contract began trading by hedge funds that bets on home-equity securities backed by adjustable-rate loans to sub-prime borrowers, not as a hedge strategy but as a profit center. When bearish trades are profitable, their bets can easily become self-fulfilling prophesies by kick-starting a downward vicious cycle."

The US charter and the GSEs' role in guaranteeing about 46% of the $12 trillion US mortgages outstanding led to expectations that the government would stand behind the agencies' debt. Standard & Poor's assigned the debt top ratings, citing the agencies' "explicit and implicit support" from the government.

Moral hazard effect

The bailout of Bear Stearns Cos arranged by the Federal Reserve in March signaled to the market that the government would not allow the GSEs to fail or default on their debts. It is clear evidence of the moral hazard effect on the financial market from bailing out one institution. With all the exposure that all banks and non-bank institutions and central banks have to Fannie and Freddie debt default, the ripple effect through the whole financial system would be unbelievable if they were allowed to fail. It was also clear evidence of the "too big to fail" doctrine.

The risk surrounding Fannie Mae was reflected in the GSE's latest sale of $3 billion of two-year benchmark notes at higher yields over benchmark rates than in previous offerings. The 3.25% notes, which mature August 12 2010, priced to yield 3.27%, or 74 basis points more than comparable US Treasuries. The company in June 2008 sold $4 billion of three-percent notes maturing July 12 2010, that priced to yield 3.036%, or 65 basis points more than Treasuries.

The government has been leaning on the GSEs to help revive the home mortgage market. Congress lifted growth restrictions on the companies, eased their capital requirements and allowed them to buy bigger, so-called jumbo mortgages, to spur demand for home loans as private lenders fled the market. The decision to use Fannie Mae and Freddie Mac as part of a $300 billion housing stimulus plan strengthened perceptions of the government's support of the GSEs. Their share of new conforming mortgages, or loans of $417,000 or less, almost doubled to 81% in the first quarter of 2008, according to the Office of Federal Housing Enterprise Oversight (OFHEO), the regulator. It appears that the fire engines caught on fire on its way to the scene of the fire.

Merrill Lynch analyst Kenneth Bruce said in a report that the "highly levered financial institutions" would have pretax credit-related losses of $45 billion, suggesting that Fannie and Freddie are going to have to raise more capital, but the market does not think they are going to be able to raise capital when they need to at a cost they can live with. The New York Times reported on the night of July 13 2008 (Sunday) that discussions among senior US government officials had heated up with respect to the US taking over Freddie Mac and Fannie Mae before markets opened in Asia. The structure being contemplated is a "conservatorship", which is permitted under a 1992 law and is one that would essentially wipe out the two GSEs' respective equity while allowing their loans to be managed.

Conservatorship is another fancy term of nationalization. The scheme allows the government to pretend the GSEs' liabilities are not its own even after it assumes them. A finding from the Office of Federal Housing Enterprise Oversight, the enterprises' regulator, that the GSEs are "critically undercapitalized" would be needed for conservatorship application. Up to now, the OFHEO has sent out the opposite message to the public. It will have to announce a 180-degree "correction" to shift quickly from "adequately capitalized" to "critically undercapitalized" for the government's proposal to work.

But unlike 1933 in the days of the New Deal when deficit financing was an operative option to revive the economy because the government was relatively free of debt, the US in 2008 is already deeply in debt, having operated with deficit financing in a boom time for more than two decades. Estimates suggest that for each ten percent decline in Freddie/Fannie assets value, a loss of $150 billion would result, equivalent to the cost of the Iraq War to date. And Fannie has lost eighty percent of market capitalization and Freddie has lost seventy percent to date.

Soaring government obligations

By assuming the GSEs' combined $5 trillion in liabilities, the US government's total obligations would soar from $9.5 trillion to $14.5 trillion. This will raise the per capita national debt from $31,250 to $47,650. The added debt is one and a half times the Bush Administration proposed 2008 fiscal budget of $3.1 trillion. While the agencies own housing-related assets that roughly match their liabilities, the still-collapsing housing market makes their value uncertain. This will unavoidably force the dollar to fall and dollar interest rates to rise. Meanwhile, the turmoil is impeding or even paralyzing the GSEs in their crucial life-support role for the housing market.

An analyst's early July report from Lehman Brothers, an investment bank itself on the brink of collapse, provoked the market panic over the GSEs. Lehman, a major player in the mortgage-backed securities market, lost as much as tweny percent in intraday trading on talk that PIMCO, the world's largest bond trader, no longer was conducting business with the Wall Street firm. Then William Poole, a respected former chief of the St Louis Federal Reserve, now a private investment advisor since July 1 2008, observed that Fannie and Freddie were technically insolvent in the first quarter this year on a mark-to-market basis. Such information was not news - in a 2006 speech, Emil Henry, then a Treasury assistant secretary, likened a failure of one of the GSE companies to a "single gunshot setting off an avalanche" - and had no bearing on the GSEs' solvency in regulatory terms. Yet the new unsettling attention on two market leaders of overwhelming scale in an uncertain climate threw financial markets into a downward spin.

Fannie and Freddie were the original inventors of mortgage-backed security, a key cause of the housing bubble and its subsequent deflation. These GSEs received credit and recognition for ingenuity in unbundling risk and reselling mortgage-backed securities to buyers of varying risk appetite in the global market. It was the secret behind the US housing boom and the enabling idea behind the structured finance market. Alan Greenspan, former Federal Reserve chairman, praised it ceaselessly as an ingenious breakthrough that did much to widen home ownership. But the development weakened the mortgage originators' oversight of loan quality.

Greenspan accepted the risk as part of the natural phenomenon of "bad loans are made in good times". The backing of the GSEs enabled securitization of "ninja" mortgages (no income, no job or assets), loans that no one would buy if they were not guaranteed by the government. Thus the fault did not lie with mortgage originators, for they would not be able to issue shaky mortgages unless there was a market for them. GSEs' abuse of their alleged government guarantee had rendered market discipline inoperative, allowing the system to go on a wide joyride that was bound to crash of a cliff. Because of their complexity and broad distribution, when securitized debts default, restructuring is almost impossible. There is no effective fire break once the fire begins and quickly engulfs the whole market.

The sooner the need for a systemic restructure is acknowledged and acted upon, the better it would be for the long-term health of the economy, or the future of regulated market capitalism itself. However, hybrid solutions of quick fixes to paper over seismic financial faults are being proposed to enable the evasion of responsibility and for political advantage in an election year.

Treasury Secretary Henry Paulson said on Friday, July 6 this year that the government would support the GSEs "in their current form as they carry out their important mission". On Sunday, the Treasury issued a statement indicating that

"... its main focus was still on supporting Fannie and Freddie in their current form. Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction. GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure."

Regulatory reform while necessary cannot be backdated. There are $5 trillion of outstanding debt instruments written under problematic regulatory oversight that need to be dealt with. Expressions of support for the "current form" that has proved wanting by a wide margin, a new line of credit to support bad loans and a proposed unlimited injection of capital by government that would surely face congressional opposition is a prescription to muddle through a major structural rupture.

Government support

The ability of the GSEs to raise new capital and credit from private sources is totally dependent on government support. Thus the plan to support these GSEs in distress will be much more costly if it must be done through private profit incentives. The outcome is likely to be a new contraction in the supply, and increase in the cost, of mortgage finance - further lessening the chances of an early recovery in the housing market and the wider economy. Private profit incentive overwhelming public interest got the GSEs in trouble. How can more private profit incentives be expected to get them out of trouble?

The Fed has announced that it will allow Fannie Mae and Freddy Mac to borrow from its discount widow, normal open only to commercial banks and since March 2008 open also to investment banks as part of the bail out of Bear Stearns. Under a three-part proposal by the Treasury, the Fed will also be given a consultative role in setting capital requirements and other regulatory standards for Fannie and Freddie, as part of an evolution to be the top regulator and overseer of the nation's financial system.

Former Fed chairman Paul Volcker expressed concern that by expanding its role of lender of last resort to institutions beside commercial banks that previously were not allowed to hold positions in equities, the Fed may have opened itself up to moral hazard dangers if large institutions believe their adventurous behavior will be bailed out by the Fed.

With the Fed, whose perspective tends to align with those of its member banks, taking over many of the regulatory powers of the Security Exchange Commission, whose mandate was originally to protect the interest of small investors, the public interest may face further diminished protection.

Yet the financial market has irreversibly changed with the emergence of structured finance in which loan securitization has taken loans that once had to stay in the balance sheets of issuing banks but are now securitized and sold by brokers to institutional investors worldwide. Default of a major broker default, such as Fannie and Freddie, will be as damaging as failure of a major money-center bank and cause catastrophic collapse of the credit market.

In 1968, then president Lyndon Johnson, as part of his Great Society program, turned Fannie into a shareholder-owned company as part of a national housing policy to make finance capitalism finance the nationalization of housing. It was the beginning of corporate market socialism in the name of populist economic democracy. The public could only benefit if corporate and financial institutional interests could profit first. And the public must pay if market capitalism fails systemically, absolving the losses of wayward corporations and financial institutions.

In 1970, the savings and loan industry, envying the huge profit made by commercial and investment banks from Fannie Mae, called for and received congressional approval for a GSE of their own and Congress created Freddie Mac. Like the Urban Renewal program of the 1950s, the GSEs served a coalition of interest that included liberals who wanted to help low-income households, real state developers that wanted guaranteed demand, home builders that wanted a guaranteed market, local politicians who wanted tax revenue from redevelopment, banks that wanted lucrative risk-free loan proceeds and congressmen who wanted campaign contributions from mortgage lenders.

Too good to be true

Low-income voters were first dazzled by the new homes they were able to acquire with no money down and with monthly payments financed with home equity loans as house prices rose. They acted like Pinocchio in a Pleasure Island - that would soon turn them into jackasses to be sold to work in salt mines. The financial institutions were comforting their pangs of conscience over taking loans off their balance sheets as soon as they made them by excusing themselves with the idea that they were making low-cost mortgage available to millions of homebuyers. Neoliberal economists were celebrating the US miracle of mass capitalism that does not need capital.

The program of passing unsustainable loans to faceless investors benefited also land speculators, home builders, real estate agents, investment bankers, structured financiers and household furnishers. Since the main thrust of the GSE program was to help low- and moderate- income homebuyers, opposition was considered undemocratic.

Yet everyone knows that the GSEs face an interest-rate risk in their long-term mortgages if interest rates should rise over the loan period. To protect itself from interest rate risks, the GSEs use derivatives to hedge against interest-rate risk.

The OFHEO was created by the House Banking Committee chaired by Texas populist Henry Gonzalez in 1992 with minimal power to regulate the two giant GSEs on the ground that GSEs were institutions intended to support the national policy of a nation of homeowners by making housing loans affordable and should be exempt from regulation regulating commercial institutions.

The problem of this good policy intention was that during the era of neoliberal ascendancy, the light regulatory environment was used to negate a more fundamental economic law: the need to increase worker income to match mortgage payments, subsidized or not.

The GSEs have been financially successful because they combine private sector appetite for profit with access to government-backed credit at below market rates. It was a way to nationalize housing through the free market capitalism. The problem was that financial manipulation cannot replace the need for adequate income growth. The mismatch of income with asset price is the definition of a financial bubble. People were buying homes with cheap credit at prices that their income could not afford. The more home prices rose due to cheap credit, the more homeowners fell into the debt trap.

Yet in all the current talk about finding ways to deal with the crisis, not one single voice is heard from official circles about the need to increase worker income. Instead, false hopes on one-time stimulant tax rebates are hailed as the magic bullet.

Suddenly this summer, Fannie and Freddie's relatively anemic capital supply is a serious concern for the market. In one week in July, Fannie's stock plummeted to $10.25, down 74% in 2008. Freddie's shares also dived, closing at $7.75, a loss of 77% this year.

Even as investors stampede out of these battered stocks, the sycophants of free market capitalism in Washington, led by Treasury Secretary Paulson and Federal Reserve chairman Ben Bernanke, rushed to reassure the market, pointing out that the mortgage giants' regulators had confirmed that the companies were "adequately capitalized", trying to give the impression that regulators had the problem firmly in hand and that no new capital was needed by the GSEs.

But these two leaders had lost much credibility since in August 2007 when they voiced a similar mantra that problems in the mortgage market were "contained" to subprime loans and would not spread beyond. SEC chairman Christopher Cox tried to calm investors by telling them that Bear Stearns passed financial muster only days before it required a Fed-engineered bail out by JP Morgan Chase with Fed loans.

More than capital adequacy is at risk. The credibility of the team with responsibility for the nation's monetary system and its financial market is heading for a meltdown. Unfortunately, credibility is much easier to lose than to regain. (See America's Untested Management Team Asia Times Online, June 17 2006.)

Recurring anxiety

Anxiety about Fannie and Freddie's liabilities of more than $5 trillion getting too big for the funding authority of the Federal Reserve of a measly $2.5 billion credit line has been a recurring concern in many quarters in recent years. Even after both GSEs were found to be infested with accounting irregularities (Freddie Mac in 2003 and Fannie Mae in 2004), Congress failed to act, except to make the regulator require the GSEs to hold thirty percent more capital than the minimum previously required, in effect capping their ability to purchase mortgages when the housing bubble was approach its peak.

Still, Fannie and Freddie were allowed to pose as high-growth companies whose shares were safe enough for widows and orphans. GSE market share fell to 45% at the peak of the housing bubble. After the bubble burst, it rose to 68% in the first quarter of 2008.

After empty official assurances failed to convince the market because it was plain for all to see that the two GSEs' direct and guaranteed liabilities were almost 65 times their regulatory capital at the end of the first quarter of 2008, the near-term priority was to restore the rapidly fading confidence of buyers of Fannie's and Freddie's debt, many of whom are foreigners. By increasing the GSEs' credit line and pushing for authority to inject fresh equity if necessary, the Treasury's proposed plan appears to be aimed at allaying fears of widespread counterparty default and market failure. Freddie seemed to have no serious problem offloading $3 billion of new paper on Monday, July 14, although arm-twisting was rumored to have been needed to persuade banks to buy it.

The bigger problem for Washington is that merely stabilizing Fannie and Freddie is not enough. With US banks seriously distressed by the credit crisis, the GSEs, which hold or guarantee 22% of the $24.3 trillion outstanding debts borrowed by US households and the non-financial sector, are a major source of credit. Yet the market is clearly uncomfortable with the inability of the GSEs to maintain its over-bloated balance sheet. The options are either to shrink the balance sheet drastically, thus exacerbating the credit crisis, or to seek a massive injection of new capital, both requiring government action at an unprecedented scale.

Despite these ad hoc measures, which may or may not receive congressional approval, the whole world knows that credit capacity is shrinking drastically in the market. There are rumors that the US is pressing foreign central banks to acquire more GSE debt, but the market is inundated with fear of new crises before the housing market recovers. And the housing market is lying in a coma in intensive care with an oxygen tank of new credit running near empty.

As the housing market collapses, both GSE companies are reporting steep losses. But the subprime mortgage meltdown has also made the GSEs more important than ever in holding up the housing finance sector. Since the credit markets seized up, Fannie and Freddie have regained their central role in mortgage finance after losing significant market share to investment banks during the housing boom. They have issued the vast majority of mortgage securities sold in the last six months because investors have lost confidence in deals put together by big investment banks.

In February 2008, prodded by the Treasury, federal regulators announced they were easing some restrictions on lending by Fannie and Freddie. Then on March 19 the federal government announced that it was easing those restrictions in an effort to calm the turmoil afflicting the mortgage markets. Officials said the change could allow the two GSEs to invest $200 billion more in mortgages.

Alarmed by the sharply eroding market confidence in the nation's two GSEs, the largest mortgage finance companies, the Bush administration announced plans on Sunday, July 13 to ask Congress to approve a sweeping rescue package that would give officials the power to inject unlimited funds into the beleaguered companies through investments and loans.

In a separate announcement, the Federal Reserve said that at the request of the Treasury it would make one of its temporary short-term lending programs at the discount window available to the two GSEs, "to promote the availability of home mortgage credit during a period of stress in financial markets". The program for the GSEs would end when Congress approves the Treasury's proposed plan.

Treasury Secretary Paulson announced dramatically Sunday on the steps of the Treasury building: "The president has asked me to work with Congress to act on this plan immediately. Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction."

Paulson paradox

While officials in successive administrations, both Republican and Democrat, have for many years repeatedly denied that the trillions of dollars of debt Fannie and Freddie issued is guaranteed by the government, the Paulson package, if adopted, would bring the Treasury closer than ever to exposing taxpayers to potentially huge new liabilities. The two GSEs are expected to face significant new losses this year as the wave of housing foreclosures continues and rises. Paulson seemed to suggest that there is no choice but for the government to intervene. The proposed plan, requiring the Treasury to be giving authority by Congress to command unlimited funds to stabilize the GSEs, is predicated on the hope that the very availability of unlimited funds would make it unnecessary to use them. The investment and lending elements of the proposed plan are to last two years.

Over the weekend, Treasury officials sought assurances from Wall Street firms that the $3 billion auction on Monday by Freddie Mac of short-term debt would go off without a hitch. While $3 billion is a relatively small sum for an institution of Freddie's size, officials said they did not want to risk even a small misstep that could set off a new round of problems. Despite repeated assurances by top officials that the companies had adequate cash to weather the current financial storm, Fannie and Freddie had suffered a withering blow of confidence the week before. As a result, Freddie was faced with an uncertain debt offering on Monday. Should Fannie and Freddie fail, $5.3 trillion in mortgage debt would go unpaid. As it happened, the offering went smoothly but everyone knew it was not a normal market.

Freddie Mac continued to try to raise capital from private investors even after a government rescue plan it and its sister company Fannie Mae was announced the weekend before, indicating concern that the government plan may be delayed in Congress. On Friday, July 18, Freddie Mac cleared one of the last obstacles to raising new capital through a planned $5.5 billion stock offering when it received approval to register with US securities regulators. However, Freddie Mac's ability to attract much-needed capital from new and existing shareholders has been potentially lessened by the possibility of a future government stake that might place restrictions on the business. There is also little clarity with regard to where in the capital structure the government might invest, and how dilutive such a move would be to existing shareholders.

The government's rescue plan, which would allow the Treasury unlimited powers until the end of 2009 to increase its credit line to Fannie Mae and Freddie Mac and invest in their equity, met some strong vocal resistance in Congressional hearings during the week before July 18.

While many expect Congress to have no option except to approve the Paulson plan, a few skeptics were voicing their opposition in public hearings. Senator Jim Bunning, a Republican from Kentucky, described Paulson as "asking for a blank check ... for this unprecedented intervention in our free markets". He also vowed to try his best to stop a proposal that would give the Federal Reserve sweeping new powers aimed at protecting the nation's shaky financial system. Bunning said the Federal Reserve "can't be trusted with the power it already has". He says the Fed's policies in recent years have contributed to economic woes, including surging inflation, a declining dollar and the housing bust.

"When I picked up my newspaper yesterday, I thought I woke up in France. But no, it turns out socialism is alive and well in America. The Treasury Secretary is asking for a blank check to buy as much Fannie and Freddie debt or equity as he wants. The Fed's purchase of Bear Stearns' assets was amateur socialism compared to this", thundered the Republican Senator against his own party's Treasury secretary. In US political discourse, socialism is a dirty word, albeit what Paulson proposes is not anywhere near what socialism is commonly understood to be in the rest of the world, but a scheme to use public funds to save debt capitalism by frustrating the right to fail in market capitalism.

Predatory lending

Ron Paul, Republican congressman from Texas, told Bernanke that the Federal Reserve is a "predatory lender". But he did not mention that by law, predatory lenders forfeit any right of collection.

Lender liability is embodied in common and statutory law covering a broad spectrum of claims surrounding predatory lending. It is a key concept in environmental-cleanup litigation. If a lender knowingly lends to a borrower who is obviously unable to make reasonable beneficial gain from the use of the funds, or causes the borrower to assume responsibilities that are obviously beyond the borrower's capacity, the lender not only risks losing the loan without recourse but is also liable for the financial damage to the borrower caused by such loans. For example, if a bank lends to a trust client who is a minor, or someone who had no business experience, to start a risky business that resulted in the loss not only of the loan but of the client trust account, the bank may well be required by the court to make whole the client.

In the United States, although predatory lending is not defined by federal law, and various states define abusive lending differently, it usually involves practices that strip equity away from a homeowner, or equity from a company, or condemn the debtor into perpetual indenture. Predatory or abusive lending practices can include making a loan to a borrower without regard to the borrower's ability to repay, repeatedly refinancing a loan within a short period of time and charging high points and fees with each refinance, charging excessive rates and fees to a borrower who qualifies for lower rates and/or fees offered by the lender, or imposing new unjustifiably harsh terms for rolling over existing debt. Predation breaks the links between an economy's aggregate resource endowment and aggregate consumption and between the interpersonal distribution of endowments and the interpersonal distribution of consumption.

The choice by some to be predators decreases aggregate consumption, both because the predators' resources are wasted and because producers sacrifice production by allocating resources to guarding against predators. Much of welfare economics is based on the concept of pareto optimum, which asserts that resources are optimally distributed when an individual cannot move into a better position without putting someone else into a worse position. In an unjust global society, the pareto optimum will perpetuate injustice.

Now, there is a close parallel in most Third World debts and International Monetary Fund (IMF) rescue packages to the above predation examples, where sophisticated international bankers knowingly lend to dubious schemes in developing economies merely to get their fees and high interest, knowing that "countries don't go bankrupt", as Walter Wriston, former chairman of Citibank, once famously proclaimed.

The argument for Third World debt forgiveness contains large measures of lender liability and predatory lending. Debt securitization allows predatory bankers to pass the risk to global credit markets, socializing the potential damage after skimming off the privatized profits. The housing bubble has been created largely by predatory lending without any lender liability. The argument for forgiving Third World debt is applicable to low- and moderate-income home mortgage borrowers in the US as well. Let's hear some proactive commitments from the presumptive candidates of both political parties instead of empty populist campaign rhetoric.


Henry C K Liu is chairman of a New York-based private investment group. His website is at

Copyright 2008 Asia Times Online (Holdings) Ltd. All rights reserved.

Bill Totten


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