[R-G] [BillTottenWeblog] Debt capitalism self-destructs

Sat Aug 9 17:43:22 MDT 2008

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 http://www.henryckliu.com.

http://www.atimes.com/atimes/Global_Economy/JG22Dj06.html

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