Arvin migratory farm workers' camp in Kern County, California.
"Tom Collins, manager of Kern migrant camp, with drought refugee family."
Ilargi: What do you mean, you’re surprised?
Less than a week after the GSE bail-out was announced, leaving even Congress powerless to do anything but impose a few minor amendments, the real problems at Fannie and Freddie surface. Both are so soaking underwater wet in loans on properties that are fast losing value, and even more in securities that have already lost their value, that the only way from here is down. They will never resurface.
Mere days after Paulson makes the government guarantee explicit, citing the need for Fan and Fred to keep buying mortgages, and praising their sound capitalization, Freddie Mac states that they will greatly reduce the purchase of mortgages, due to the fact that they are not at all well capitalized.
Think Paulson didn’t know that last week? That the 8-year former CEO of Goldman Sachs, and all his friends and highly-paid employees, failed to figure that out?
Bill Fleckenstein makes a lot of sense in "Feds can't fix Fannie and Freddie", but still, that title misses the main point: The Feds are NOT TRYING to fix or save them. What they ARE doing is this: they are transferring the losses, as inescapable as they are enormous, that lie in wait inside the books of the two companies, from their friends, rich investors at home and abroad, to the US taxpayer.
The Goldman crowd is playing you for a bunch of fools, and if you let them, that’s what you are.
Freddie Mac To Slow Purchases of Mortgages, Bonds
Freddie Mac, the second-largest U.S. mortgage-finance company, may cut purchases of home loans from banks and bonds backed by housing debt to shore up its capital amid record delinquencies.
The government-sponsored company is also considering selling securities and reducing its dividend while it prepares to issue $5.5 billion of stock, McLean, Virginia-based Freddie Mac said in a July 18 filing with the U.S. Securities and Exchange Commission. JPMorgan Chase & Co. analyst Matthew Jozoff said in a report last week that growth in mortgage holdings of Freddie Mac and the larger Fannie Mae will be "weak."
"This just means much less credit availability for mortgage borrowers," said Paul Colonna, who manages more than $100 billion as chief investment officer for fixed income at GE Asset Management in Stamford, Connecticut. "They were teed up to be saviors of the mortgage crisis, but now they've got their own capital issues."
The Bush administration and Congress are depending on the companies to help pull the U.S. out of the housing slump because they buy mortgages from banks, providing money to make new loans. Instead, Treasury Secretary Henry Paulson was forced to seek Congressional approval last week to extend more credit to the companies and buy their shares after Freddie Mac and Fannie Mae tumbled this year in New York Stock Exchange composite trading.
Freddie Mac lost 73 percent in New York trading this year and Fannie Mae declined 66 percent. Combined losses at the companies will probably total $48 billion through 2009, New York-based Jozoff said in the JPMorgan report dated July 18. "Mortgage losses are significant, and will probably foster capital conservation from the agencies rather than portfolio growth," he wrote.
Fannie Mae, created in Franklin Delano Roosevelt's New Deal plan, and Freddie Mac, started in 1970, are getting battered as foreclosures rise to the highest rate in at least three decades, the Mortgage Bankers Association said in a June report. One in every 501 households was in a stage of foreclosure in June, and bank seizures rose 171 percent since January, 2005, according to RealtyTrac Inc., an Irvine, California-based company that sells data on defaults.[..]
Freddie Mac will probably report a surplus exceeding the minimum 20 percent required for the second quarter, according to the SEC filing. The SEC registration and equity raising will allow the company to reduce its capital surplus level to 10 percent. While that should allow Freddie Mac to buy more mortgages, the company suggested it still needs to preserve capital.
To stay above the 20 percent requirement "we are considering measures such as reducing or rebalancing risk, limiting growth or reducing the size of our retained portfolio, slowing purchases into our credit guarantee portfolio, issuing additional preferred or convertible preferred stock, issuing common stock, and reducing the dividend on our common stock,'' Freddie Mac said.
Fannie Mae and Freddie Mac need less capital for their business of applying guarantees to mortgage securities. The companies must hold 2.5 percent of capital against their $1.5 trillion of investments and 0.45 percent against their guarantees of $3.6 trillion of securities.
The $5.5 billion share sale planned by Freddie Mac may not be enough, according to Friedman Billings Ramsey & Co. analyst Paul Miller. He estimated in a report today that the companies will each need to raise $10 billion to $15 billion to replenish capital. The U.S. government will seek to avoid having the companies shrink their portfolios, he added.
"The government may have to intervene through a capital infusion, and in an extreme-case scenario, through taking on the agencies' balance sheet," he said. Freddie Mac probably would split fund-raising between common and preferred shares, UBS AG analysts said in a July 10 report. With Freddie Mac's market capitalization now at $5.9 billion, shareholders may suffer a 50 percent dilution of their stakes.
Fixed-rate mortgage securities guaranteed by Fannie Mae, Freddie Mac or U.S. agency Ginnie Mae yielded 157 basis points, or 1.57 percentage points, more than Treasuries, according to Lehman Brothers Holdings Inc. index data. The spread compares with 69 basis points a year earlier.
"There's certainly fear among some investors that they might engage in large-scale selling," said Arthur Frank, head of mortgage-backed securities research at Deutsche Bank Securities in New York.
Feds can't fix Fannie and Freddie
The mortgage giants aren't short of cash. They're stuck with bad loans that aren't going away. Also: Short sellers didn't bring down the lenders -- the lenders did it themselves.
As the Treasury prepares to ride to the rescue of Fannie and Freddie, it's worth noting one little detail: That so-called plan is in reality just a concept.
Fannie Mae and Freddie Mac do not have a liquidity problem that can be solved by the Federal Reserve or even by an injection of Treasury capital. It's a solvency issue. Short-term cash isn't the real problem. Over time, the mortgage giants' liabilities are quite likely to swamp their assets. Thus their assets are contingent, but their debts are forever.
Further, if the Treasury is the only entity left willing to buy shares to shore up Fannie and Freddie, what will happen to other troubled financial institutions? Between now and the year's end, more mortgages will percolate through those institutions' balance sheets, creating losses that will force them to seek capital as well.
As for access to the Fed's discount window, even if Fannie and Freddie use it, that won't change much. Lehman Bros. has had access to the discount window, and that has done Lehman little good. Nor has it healed Washington Mutual, Bank of America, Citigroup, etc.
The rapidly growing disaster the country faces, in addition to the financial one, is a recession that's worsening -- a reality depicted in widespread images of depositors lined up at IndyMac bank. (A friend of mine known as Mr. Mortgage has also noted lines at multiple locations of Washington Mutual.) I suspect that as this process moves forward, many regional banks will experience modest runs, because fear becomes contagious at some point. And fear eventually leads to panic.
This is all part of the next-time-down thesis that took forever to arrive, due to monkeying with the financial system by Wall Street and the government. But it is finally here.
As the process plays out, it will further hamper people's ability to make mortgage payments. That will impair mortgage assets, with a feedback effect on housing prices. Of course, our currency will continue to be undermined by what the Fed and the government want to do. You can quickly see how intertwined the real-estate market, stock market, economy and currency are.
As far as the stock market goes, fear has not yet morphed into panic, but I think we will get to that point. On the upside, folks often forget that markets are ruled by people -- who, at the end of the day, are ruled by their emotions. There can never be a new era because human nature remains the same.
For now, fear has not reached panic levels. In fact, I am amazed by the complacency of so many stock operators, who act as though their greatest fear is missing the next rally. I guess that's how former Fed Chairman Alan Greenspan's policies over the past 25 years have conditioned financial muscle memory -- to believe that nothing ever goes wrong for long.
Turning to wrongheaded finger-pointing, I found it interesting that Securities and Exchange Commission Chairman Chris Cox wants to amend rules for naked short selling (though his proposals are much ado about nothing, as it is already illegal), specifically in the cases of Fannie, Freddie and certain brokers.
I know I've said this before, but since there's been so much chatter about short sellers, let me once again try to make this perfectly clear: Short sellers didn't create the housing bubble, which is what caused the unfolding disaster. Nor did they make the bad loans now going sour.
Short sellers do not ruin companies, and they are incapable of driving a company's stock price lower for more than a brief moment. If unscrupulous manipulators decided to pressure a stock lower, that would be a recipe for losing money unless they were extremely quick, not only to sell but also to cover the short position.
Should the government bail out the 2 mortgage giants or let them fail? Jim Jubak says the shareholders should take their medicine and support the debt. Likewise, short sellers didn't cause Bear Stearns to collapse. That was a do-it-yourself job, executed by the arrogant chieftains who let themselves get wildly over-leveraged.
And someone might tell Cox that short sellers didn't ruin Fannie Mae. That was the handiwork of former CEO Franklin Raines and the rest of management (as well as the regulators), whose Enron-like greed caused me to name the company "Fanron" on Feb. 23, 2005. As I wrote in my daily column on my Web site that day:
"Problems there definitely matter, since Fannie has been one of the primary engines that finance the housing ATM. In yet another turn for the worse, OFHEO stated that it has 'identified (additional) policies that it believes appear inconsistent with generally accepted accounting principles.' When I read this morning's OFHEO headlines (concerning Fannie's 'held for sale' loans and 'use of FAS 140' hedge accounting), I thought this smells, just like Enron, ergo, my new nickname for Fannie -- Fanron."
This business of blaming short sellers for lower stock prices (and speculators generically for high oil prices) is getting ridiculous, especially when the real perpetrators suffer minor consequences as they walk away with giant piles of money.
Ilargi: It’s official: 1/ Paulson is not up to the task (too much to grab even for his sticky little fingers), and 2/ Da Boyz expect a mountain of work, and soon.
One thing, guys, I know that what I call Goldman’s unrelenting powergrab, you will call consolidation. But for Beelzebub’s sake, stop calling it "public service".
Banker Leaves Goldman Sachs To Aid Paulson
Goldman Sachs Group Inc.'s most senior financial-institutions banker, Ken Wilson, is temporarily leaving the firm to advise Treasury Secretary Henry Paulson on how to resolve the country's banking crisis, according to people familiar with the matter.
As chairman of Goldman's Financial Institutions Group, Mr. Wilson has proved to be a big player in capital raisings and reorganizations across the banking sector. In joining Mr. Paulson, a close friend and longtime colleague, Mr. Wilson will try to address issues from a more macro perspective.
The Treasury and Federal Reserve are grappling with how to respond to the threat of bank failures, flagging capital levels and crises of confidence in important institutions such as Fannie Mae and Freddie Mac.
While a number of details still must be worked out, Mr. Wilson, 61 years old, is expected to serve without pay, in a period through January, the people familiar with the matter said. President George W. Bush made a personal call to Mr. Wilson in recent days, asking him to assist Mr. Paulson.
Mr. Wilson's appointment is the latest in the ranks of Goldman employees who have moved into public service. And it reflects the seriousness of the issues before the Treasury, which is trying to instill public confidence in the financial system without pushing the federal government into a posture of expensive public bailouts.
The (further) ‘Goldmanisation’ of US finance
Well, well, what a surprise: (yet) another Goldman Sachs banker is preparing to impart his wisdom - and presumably influence - to the US administration.
In what could only be described as further “Goldmanisation” of the US economy, Ken Wilson, Goldman’s top financial-institutions banker, will “temporarily” leave the firm to advise Treasury secretary Hank Paulson on how to resolve the country’s banking crisis, according to the Wall Street Journal.
The move is the latest in a series of Goldman to US administration transfers, notable among them Paulson himself and before him, the likes of Bob Rubin as Treasury secretary and quite a few others. This one was at the personal request of George W. Bush, who called Wilson in recent days to convey his invitation, according to the Journal.
As chairman of Goldman’s Financial Institutions Group, Wilson has played a big role in capital raisings and reorganisations across the banking sector, and will join Paulson to “address issues from a more macro perspective”, the paper said. Wilson’s move comes as the Treasury and Federal Reserve contemplate the prospect of more bank failures, “alarming capital levels” and “crises of confidence” in important institutions such as Fannie Mae and Freddie Mac.
Oh, and in a display of what is clearly intended to appear as selflessness (and a very high pay-grade), Wilson is expected to serve without pay in a stint that will last through January.
The global economy is at the point of maximum danger
It feels like the summer of 1931. The world's two biggest financial institutions have had a heart attack. The global currency system is breaking down. The policy doctrines that got us into this mess are bankrupt. No world leader seems able to discern the problem, let alone forge a solution.
The International Monetary Fund has abdicated into schizophrenia. It has upgraded its 2008 world forecast from 3.7pc to 4.1pc growth, whilst warning of a "chance of a global recession". Plainly, the IMF cannot or will not offer any useful insights.
Its "mean-reversion" model misses the entire point of this crisis, which is that central banks have pushed debt to fatal levels by holding interest too low for a generation, and now the chickens have come home to roost. True "mean-reversion" would imply debt deflation on such a scale that would, if abrupt, threaten democracy.
The risk is that these same central banks will commit a fresh error, this time overreacting to the oil spike. The European Central Bank has raised rates, warning of a 1970s wage-price spiral. Fixated on the rear-view mirror, it is not looking through the windscreen.
The eurozone is falling into recession before the US itself. Its level of credit stress is worse, if measured by Euribor or the iTraxx bond indexes. Core inflation has fallen over the last year from 1.9pc to 1.8pc. The US may soon tip into a second leg of this crisis as the fiscal package runs out and Americans lose jobs in earnest.
US bank credit has contracted for three months. Real US wages fell at almost 10pc (annualised) over May and June. This is a ferocious squeeze for an economy already in the grip of the property and debt crunch. No doubt the rescue of Fannie Mae and Freddie Mac - $5.3 trillion pillars of America's mortgage market - stinks of moral hazard.
The Treasury is to buy shares: the Fed has opened its window yet wider. Risks have been socialised. Any rewards will go to capitalists. Alas, no Scandinavian discipline for Wall Street. When Norway's banks fell below critical capital levels in the early 1990s, the Storting authorised seizure. Shareholders were stiffed.
But Nordic purism in the vast universe of US credit would court fate.
The Californian lender IndyMac was indeed seized after depositors panicked on the streets of Encino. The police had to restore order. This was America's Northern Rock moment. IndyMac will deplete a tenth of the $53bn reserve of the Federal Deposit Insurance Corporation. The FDIC has some 90 "troubled" lenders on watch. IndyMac was not one of them.
The awful reality is that Washington has its back to the wall. Fed chief Ben Bernanke thought the US could always get out of trouble by monetary stimulus "à l'outrance", and letting the dollar slide. He has learned that the world is a more complicated place. Oil has queered the pitch.
So has America's fatal reliance on foreign debt. The Fannie/Freddie rescue, incidentally, has just lifted the US national debt from German 'AAA' levels to Italian 'AA-' levels. China, Russia, petro-powers and other foreign states own $985bn of US agency debt, besides holdings of US Treasuries. Purchases of Fannie/Freddie debt covered a third of the US current account deficit of $700bn over the last year.
Alex Patelis from Merrill Lynch says America faces the risk of a "financing crisis" within months. Foreigners have a veto over US policy. Japan did not have this problem during its Lost Decade. As the world's supplier of credit, it could let the yen slide. It also had a savings rate of 15pc. Albert Edwards from Société Générale says this has fallen to 3pc today. It has cushioned the slump. Americans are under water before they start.
My view is that a dollar crash will be averted as it becomes clearer that contagion has spread worldwide. But we are now at the point of maximum danger. Britain, Japan, and the Antipodes are stalling. Denmark is in recession. Germany contracted in the second quarter. May industrial output fell 6pc in Holland and 5.5pc in Sweden.
The coalitions in Belgium and Austria have just collapsed. Germany's left-right team is fraying. One German banker told me that the doctrines of "left Nazism" (Otto Strasser's group, purged by Hitler) had captured the rising Die Linke party. The Social Democrats are picking up its themes to protect their flank.
This is the healthy part of Europe. Further south, we are not far away from civic protest. BNP Paribas has just issued a hurricane alert for Spain. Finance minister Pedro Solbes said Spain is facing the "most complex" economic crisis in its history. Actually, it is very simple. The country was lulled into a trap by giveaway interest rates of 2pc under EMU, leading to a current account deficit of 10pc of GDP.
A manic property bubble was funded by foreigners buying covered bonds and securities. This market has dried up. Monetary policy is now being tightened into the crunch by the ECB, hence the bankruptcy last week of Martinsa-Fadesa (€5.1bn). With Franco-era labour markets (70pc of wages are inflation-linked), the adjustment will occur through closure of the job marts.
China, India, East Europe and emerging Asia have all stolen growth from the future by condoning credit excess. To varying degrees, they are now being forced to pay back their own "inter-temporal overdrafts".
If we are lucky, America will start to stabilise before Asia goes down. Should our leaders mismanage affairs, almost every part of the global system will go down together. Then we are in trouble.
Ilargi: A small excerpt of a very long and good Bloomberg article on Citi.
Citigroup Unravels as Reed Regrets Universal Model
Vikram Pandit walks through the white stone Mexico City headquarters of Grupo Financiero Banamex SA, past Diego Rivera's 1942 Calla Lily Vendor, and into a steep, narrow auditorium for a town hall meeting with Citigroup Inc. bankers.
It's Jan. 30, and Pandit is six weeks into running the biggest U.S. financial services company. He's just spent the day talking with Manuel Medina-Mora, chief executive officer of Banamex, which New York-based Citigroup bought in 2001. Pandit, 51, born in Nagpur, India, is on a world tour of Citi offices that's also taking him to South Korea and Poland.
The Mexican executive offers Pandit, the novice CEO, something that's in short supply for Citi these days: a sliver of good news. Banamex profits doubled from 2002, the first full year the bank was part of Citi, through last year. Pandit says the Mexican bank is a model of what he wants Citi to become.
It's a one-stop bank, where some of Mexico's largest companies -- tequila maker Casa Cuervo SA is one -- do all their business, including currency hedges and stock and bond deals. Banamex also manages their owners' personal fortunes and handles their employee paychecks.
Medina-Mora, 58, points out that Latin America represented 6 percent of Citi's assets and 15 percent of its profits in the 12 months ended in June 2007. In the first half of this year, the Latin American division earned $1.85 billion. Little else looks good at Citi these days.
The company, founded as the City Bank of New York in 1812, is mired in a crisis that toppled Pandit's predecessor, Charles Prince, and has prompted $54.6 billion in writedowns and credit costs, according to Bloomberg data. That includes about $10 billion to increase reserves for future bad loans.
The bank racked up $17.4 billion in losses in the nine months ended on June 30 -- including $7.6 billion since Pandit took over in December. Citi has had to go hat-in-hand to Abu Dhabi, Kuwait and Singapore for infusions of capital. Since mid- 2007, 16,000 Citi jobs have been eliminated.
The bank made some of the biggest bets in the subprime lending debacle -- and absorbed some of the biggest losses. It has had to bail out at least nine off-balance-sheet investment funds in the past year, including seven structured investment vehicles, or SIVs, holding $45 billion of securities. And defaults are rising. Consumer loans more than 90 days past due rose 62 percent to $14 billion during the year ended on June 30.
The behemoth that Pandit heads -- the biggest credit card company, the second-biggest wealth manager, the biggest corporate securities underwriter -- is likely to suffer well into 2009 as the global economy quavers. Its shares fell 62.5 percent in the 12 months ended on July 18.
William Smith, whose New York-based SAM Advisors LLC owns about 80,000 Citi shares, says the once-mighty conglomerate that Sanford "Sandy" Weill assembled over 20 years should be broken up and auctioned off. He plans to spend the next year organizing activist shareholders. "The businesses are absolutely beautiful, but they've been suffocated," Smith says. Citi is bloated and mismanaged, he says.
Ilargi: Paulson can say what he likes. Literally: nobody in the press will demand a shred of proof for his words; it would probably cost them their jobs.
But what exactly is it, for example, that makes the US banking system so sound? If Fannie and Frddie were as well-capitalized as their regulator states, parrotted by Paulson, the all-out bail-out would never have happend. We know it and he knows it.
And if Paulson et al. are so confident about the situation, why do they change their story every single time they open their mouths? Has anyone done an overview of their utterances in the past two years? That would make for some great comedy material.
One more thing: ”He said no one has lost a single penny on an insured deposit in the 75 years that the Federal Deposit Insurance Corporation has operated”. True enough. But here’s another truth: there hasn’t been a crisis anywhere near as deep as this one in the past 75 years, not even close. And bailing out the GSE’s makes it, for all practical intents and purposes, impossible for the US Treasury to step in to bail out the FDIC as well, if 1000 banks or more go bust. That is, if the Treasury would ever have had any intention to do so.
Paulson braces public for months of tough times
Treasury Secretary Henry Paulson sought to reassure an anxious public Sunday that the banking system is sound, while also bracing people for more troubled times ahead. "I think it's going to be months that we're working our way through this period — clearly months," he said.
Paulson said the number of troubled banks will increase as they struggle to cope with big losses on bad mortgages. The government this month took over IndyMac after a run led it to become the largest regulated thrift to fail.
"Of course the list is going to grow longer given the stresses we have in the marketplace, given the housing correction. But again, it's a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation," he said in broadcast interviews.
Paulson used appearances on the Sunday talk shows to tell people that deposits up to $100,000 are fully insured. He said no one has lost a single penny on an insured deposit in the 75 years that the Federal Deposit Insurance Corporation has operated.
"We're going through a challenging time with our economy. This is a tough time. The three big issues we're facing right now are, first, the housing correction which is at the heart of the slowdown; secondly, turmoil of the capital markets; and thirdly, the high oil prices, which are going to prolong the slowdown," he said.
"But remember, our economy has got very strong long-term fundamentals, solid fundamentals. And you know, your policy-makers here, regulators, we're being very vigilant." Paulson said he hoped Congress soon would approve his plan to help shore up Fannie Mae and Freddie Mac, the government-sponsored mortgage companies.
"I'm very optimistic that we're going to get what we need from Congress here, because Congress understands how important these institutions are," Paulson said. The House plans to vote Wednesday on a housing bill that is expected to include a rescue for Fannie Mae and Freddie Mac. The companies' shares have plummeted because of fears about their financial stability.
Fannie Mae and Freddie Mac are private, but they were created by Congress to encourage homeownership by buying mortgages from banks. The two hold or guarantee more than $5 trillion in home loans — almost half of the nation's total.
"Our first priority today is the stability of the capital markets, the stability of the system. And these institutions have investors all around the world ... and those investors need to know that we in the United States of America understand the importance of these institutions to our capital markets and to our economy and to our housing market," he added.
Paulson acknowledged the U.S. is continuing to lose jobs, though he said the $168 billion economic relief plan approved this year has created jobs that would not otherwise exist. The plan included tax rebates for people and tax breaks for businesses.
Democratic leaders, including presidential candidate Barack Obama, are pushing for a second, smaller, economic installment. Paulson said he did not want to speculate about that idea.
"I'm focused on this stimulus package. It's made a difference in the second quarter. It's going to make a difference in the third quarter. We need to watch this very carefully," he said. "Right now we're going through a tough period. There is no doubt about it. But the stimulus plan is making a difference," he said. he said.
Ilargi: I don't think we'll stop talking about the FDIC for a long while. Here's a Wall Street Journal article, much longer than this little quote and worth the read, that paints the picture of the bureau that all Americans still believe insures their bank deposits, as a very shady mortgage lender.
FDIC Faces Mortgage Mess After Running Failed Bank
Federal officials heap much of the blame for the subprime mortgage mess on lenders, claiming they recklessly made too many high-cost home loans to borrowers who couldn't afford them.
It turns out that the U.S. government itself was one of the lenders giving out high-interest, subprime mortgages, some of them predatory, according to government documents filed in federal court.
The unusual situation, which is still bedeviling bank regulators, stems from the 2001 seizure by federal officials of Superior Bank FSB, then a national subprime lender based in Hinsdale, Ill. Rather than immediately shuttering or selling Superior, as it normally does with failed banks, the Federal Deposit Insurance Corp. continued to run the bank's subprime-mortgage business for months as it looked for a buyer.
With FDIC people supervising day-to-day operations, Superior funded more than 6,700 new subprime loans worth more than $550 million, according to federal mortgage data. The FDIC then sold a big chunk of the loans to another bank.
That loan pool was afflicted by the same problems for which regulators have faulted the industry: lending to unqualified borrowers, inflated appraisals and poor verification of borrowers' incomes, according to a written report from a government-hired expert. The report said that many of the loans never should have been made in the first place.
Hundreds of borrowers who took out Superior subprime loans on the FDIC's watch -- some with initial interest rates higher than 12% -- have lost their homes to foreclosure, data on the loans indicate. Banking regulators are grappling with a new round of woes related to subprime mortgages, which were generally made to people with poor credit histories.
This month, the FDIC took control of the IndyMac Bank, a major lender that specialized in higher risk loans, after it failed. The FDIC intends to keep IndyMac open, as it did with Superior, but it doesn't plan to originate any new mortgages. At the time the FDIC was running Superior, subprime lending hadn't yet emerged as the national disaster it since has become.
But some lending experts already were faulting industry practices and warning about rising delinquencies. The FDIC's problems with Superior could fuel criticism that bank regulators were slow to heed warning signs. The FDIC, one of the chief U.S. bank regulators, manages a giant insurance fund that compensates customers of failed banks, and it takes charge of banks seized by the government.
It has taken over hundreds of failed banks over the years, and generally has a good track record handling the difficult job. The Superior situation could be costly for the FDIC. Texas-based Beal Bank SSB, which bought a portfolio of Superior loans, about half of them originated under the FDIC, is suing the agency in U.S. District Court in Washington. The suit claims many of the loans were made improperly and are plagued with problems.
An internal FDIC legal assessment, obtained by Beal Bank and filed in court last month, acknowledged "numerous appraisal deficiencies" in the portfolio and a "small number of loans that appear to be fraudulent from inception."
Calling the FDIC's legal position poor, the undated 26-page assessment suggested that the agency's liability could be as much as $70 million. Another FDIC official, in a deposition, estimated that the cost of settling the case could be less than one-third that amount. In a recent court filing, the FDIC estimated that about 1,500 of the 5,315 loans it sold to Beal either have defaulted or are nonperforming.
The FDIC already has bought back another 247 of the mortgages, most of them for violations of federal anti-predatory-lending laws intended to protect borrowers from unreasonably high fees or deceptive practices. Beal Bank has said in court filings that 73 of the repurchased loans were originated while the FDIC was running Superior.
In a statement, FDIC spokesman Andrew Gray said the agency was "prepared to immediately work with Beal" to fix any additional mortgages originated under its watch that violated consumer-protection laws or the FDIC's own subprime-lending guidelines. As for the loans it has already acknowledged were predatory, Mr. Gray said the FDIC has provided recompense to affected borrowers and instructed its servicing contractor to avoid foreclosing.
Mr. Gray added that the FDIC "remains deeply concerned about consumer-protection issues. Though these loans with relaxed lending standards were commonplace during this period, time and experience has shown that the long-term interests of borrowers were not always served well by them."
Meanwhile, a separate portfolio of Superior subprime loans that the FDIC sold to Bank of America Corp. -- which the bank in turn sold to investors -- also has been troubled. As of April, investors had suffered "realized losses" -- which generally occur after foreclosures -- on 511 of the 3,964 loans in that pool, according to data provided to investors.
The vast majority of the loans were originated when the FDIC was running the bank, the data show. In May and June, two ratings agencies downgraded some securities backed by the mortgages, with one citing a large number of severely delinquent loans and other problems.
Armed and Dangerous
Last week, with the nation's financial infrastructure crumbling before our very eyes, the nation's top two economic policy makers made their way to the Congress for an extraordinary episode of political theater.
Fannie Mae and Freddie Mac, the quasi-government entities that form the backbone of America's gargantuan mortgage market, appeared to be cracking. To the somewhat bewildered members of Congress, Ben Bernanke and Henry Paulson offered radical remedies to save the lenders.
Despite the fact that the proposed policies would thoroughly redefine America's supposedly capitalistic pedigree, the moves were presented as wholly inevitable, and in the end, benevolent and costless. If you are looking for a new chapter in American history, it has just begun.
The most memorable moment in the episode came when Secretary Paulson explained that the best way to minimize the chances that Fannie Mae and Freddie Mac will need a government bailout would be for Congress to grant the Treasury unlimited authority to lend to the two institutions. His analogy: When the bad guys see a bazooka on your hip, you are less likely to be challenged to a gunfight.
At its heart Paulson's argument assumes the GSE's problems are simply a function of confidence. He believes that if the U.S. Treasury signals that it will stand behind both firms to the bitter end, then investors would have no reluctance in buying their bonds.
But assuring that creditors will be repaid (albeit with cheaper dollars) does nothing to address the root cause of the problem, which is that both firms are losing money on their loan portfolios, and on the loans that they insure.
Paulson's plan actually assures that Fannie and Freddie's losses will be even larger, and puts American taxpayers, or more precisely wage earners and savers, directly on the hook. The longer these two entities remain in business, the more bad loans they will buy or insure, and the more money taxpayers will lose.
In theory, Fannie and Freddie were originally created to help provide affordable housing. In reality, like all government programs, they achieved the opposite. Rather than making houses more affordable, they merely enabled buyers to overpay for them. The result is that American homeowners are now saddled with staggering amounts of debt, as easy credit made it possible for buyers to bid prices to dazzling heights.
So while a record number of Americans now own homes, they have bankrupted themselves in the process.
Without the help of Fannie and Freddie, and now the full faith and credit of the United States, American home buyers would be facing much steeper mortgage interest rates. This is particularly true given that our ability to borrow is now dependent on access to the global savings pool.
Without the implicit, and now explicit, government guarantee, foreigners would be much less willing to extend cheap credit to Americans. If we had to rely solely on our shallow domestic savings pool and individual credit worthiness alone, rates would be significantly higher.
Since home prices are a function of the ability of buyers to pay, higher interest rates would mean lower prices, thus making houses themselves more affordable. Even the tax deductibility of mortgage interest has achieved a similar result. By subsidizing home buying, and encouraging renters to become buyers instead, the government has artificially increased demand for houses, causing prices to rise.
In the end, the benefits of the mortgage tax deductions are limited to those who benefit from inflated home prices. This includes realtors, who earn higher commissions, governments that collect higher property taxes, and those who owned their homes prior to the loophole being enacted who cashed in on the gains.
At present, the best the government can do for housing and the economy is to leave both alone, cease interference in the free market, restore sound money, and allow capitalism to work. Unfortunately, the laws of capitalism are now demanding that home prices continue to fall precipitously.
But, based on the speed in which our government, public and financial institutions are willing to abandoned free market principals at the first whiff of economic pain, the likelihood that this impulse will take hold is increasingly remote.
So hunker down as the United States finds itself on the express track to state socialism with Paulson's Bazooka locked, loaded and pointed right at us. When the government pulls the trigger the blast will blow the dollar, and what's left of our capitalist economy, to smithereens.
Trouble at Fannie and Freddie Stirs Concern Abroad
For more than a decade, Fannie Mae and Freddie Mac, the housing giants that make the American mortgage market run, have attracted overseas investors with a simple pitch: the securities they issue are just as good as the United States government’s, and they usually pay better.
The marketing plan worked. About one-fifth of securities issued by Fannie, Freddie and a handful of much smaller quasi-governmental agencies, some $1.5 trillion worth, were held by foreign investors at the end of March. One out of 10 American mortgages is, in effect, in the hands of institutions and governments outside the United States.
Now that the two companies are at risk, how their rescue is handled will ultimately test the world’s faith in American markets. It could also influence the level of interest rates and weigh on the strength of the dollar for years to come, analysts say. “No less than the international perception of the credit quality of the U.S. government is at stake,” said Richard Hofmann, an analyst with CreditSights, an independent research house with offices in London and New York.
Also at stake is Americans’ future ability to gain access to credit. If foreign companies and governments abandon United States investments, home, auto and credit card loans will be much more difficult to come by. That helps explain why Treasury Secretary Henry M. Paulson Jr. is pressing American lawmakers for the authority to inject unspecified billions in cash into either company or both.
The “blank check” nature of his request has raised concerns on Capitol Hill, but Mr. Paulson is betting that Congress is even more fearful of the consequences of doing nothing to rescue Fannie and Freddie. On Sunday, in an appearance on the television program “Face the Nation,” Mr. Paulson said he was “very optimistic that we’re going to get what we need from Congress.” “Congress understands how important these institutions are,” Mr. Paulson said.
Asian institutions and investors hold some $800 billion in securities issued by Fannie and Freddie, the bulk of that in China and Japan. China held $376 billion and Japan $228 billion as of June 2007, the most recent country-specific Treasury figures.
In Europe, roughly $39 billion in Fannie and Freddie debt is held in Luxembourg and $33 billion more in Belgium, countries that are home to large investment management firms. Investors in Britain hold $28 billion, and Russian buyers hold $75 billion. Sovereign wealth funds in the Middle East are also believed to be big investors in Fannie and Freddie debt.
The trillions in securities issued by Fannie and Freddie and backed by American mortgages were never explicitly guaranteed by the United States government, but foreign and domestic investors alike have always believed, because of the companies’ integral role in the housing market and their marketing pitch, that the guarantee would be backed up if it were tested.
As the United States government’s debt, and the corresponding amount of Treasury securities, shrank in the late 1990s, foreign investors with currency reserves needed a safe alternative to park their cash. Fannie and Freddie stepped up their overseas marketing efforts and, with the help of Wall Street banks, sold billions of dollars in securities overseas.
Asian banks and insurers bought Fannie’s and Freddie’s paper because it gave a little more yield than a straight Treasury note — “the same risk at a better price,” said Deborah Schuler, an analyst with Moody’s Investors Service in Singapore. Investment managers at Asian banks and central governments are “very comfortable with the idea of implied government support” because it is so prevalent in Asia, Ms. Schuler said.
Still, this week’s Congressional debate on the issue “is going to worry people,” Ms. Schuler said, though she, like most analysts, is confident that Washington will deliver, just as it has in past financial crises like the savings and loan industry bailout of the late 1980s and early 1990s.
Because America’s relations with a host of countries are intricately tied to Fannie and Freddie, the only realistic option open to lawmakers may be to hand the Treasury Department that blank check, analysts say. The two housing agencies have always been fierce competitors, and they made no exception in their expansion into international markets.
Top executives wooed governments, banks and insurance companies in Asia and Europe, and lent executives to help foreign governments, including Russia and Hong Kong, set up their own American-style mortgage markets. Both companies often compared their product to United States Treasuries when they talked to international investors, and adjusted the way that bonds matured and were priced so they looked and acted more like Treasury bonds.
In an interview with a London financial trade paper in 1999, Jerome T. Lienhard, Freddie Mac’s senior vice president of investment funding, said, “Investors that make the transition from U.S. Treasuries to our securities will be pleased with the performance.” Freddie Mac’s program is “designed to mirror that already used by the United States government,” he said.
The Treasury will not comment on Fannie and Freddie’s international marketing pitches, but in the past it has tried to rein in the two institutions. In March 2000, Gary Gensler, then Treasury under secretary, proposed more oversight of Fannie and Freddie, testifying to Congress that the two agencies “receive no funds from the federal government, and the government does not guarantee their securities.”
The companies “have been promoting their debt securities as an alternative market benchmark” to Treasuries, he noted, particularly as the amount of Treasuries issued by the government shrank with the deficit. Mr. Gensler’s comments roiled mortgage markets, sending prices down sharply on traded Fannie- and Freddie-backed securities and on both companies’ stock. Ultimately, the controls he proposed were softened.
The bulk of investments related to Fannie and Freddie are in the form of mortgage-backed securities, often called agency securities or agency paper. This agency paper is considered of much higher quality than securities backed by subprime loans because Fannie and Freddie generally lend to borrowers with good credit histories and require higher down payments.
Prices on senior Fannie and Freddie securities, the highest quality, have not changed significantly since the end of last year, even as the two companies’ stock prices have plummeted, Moody’s noted. As of June 30, 2008, prices on a typical Fannie or Freddie security maturing in 10 years were off only about 2 percent from December 2007.
Questions about Fannie and Freddie have prompted individual institutions and governments in Asia and Europe to specify their exposure in recent days, but so far international concern has been limited. Ingo Buse, a spokesman for Zurich Financial Services, Switzerland’s largest insurer, said it held $8.3 billion in mortgage securities backed by Freddie Mac or Fannie Mae, and felt “comfortable with our position and asset allocation.”
Swiss Reinsurance, Switzerland’s largest reinsurer, said on Wednesday that it held $9.6 billion of corporate debt from Freddie Mac and Fannie Mae and $12 billion in mortgage securities backed by the two companies. Swiss Re’s holding of Freddie Mac and Fannie Mae shares is minimal, it said.
Hannover Re, Germany’s second-largest reinsurer after Munich Re, said it held 125 million euros, or $199 million, in securities issued by Freddie Mac and Fannie Mae. “We are not worried about the exposure,” said Stefan Schulz, a spokesman for the company, “because we expect the U.S. government to step in if there is any problem.”
Mother of All Short Squeezes?
Tuesday’s action by the SEC in amending Regulation Short Sales (RegSHO) listed 19 banks and financial companies for which naked shorting was effectively banned for 30 days. Such a limit was long overdue but why limit the restriction to just 19 companies and just 30 days?
Naked short selling (selling shares short that are not first borrowed, which is required to execute a legal short) is endemic and the SEC has turned a blind eye to it since the agency was created. This recent action is a knee-jerk reaction but a clear example of too little way too late. The question is will they have the stomach to do what it necessary and give all stocks the same naked short protection?
But like anything else, the devil is in the detail. As you can see from the chart below, the ban and rally created one mother of a short squeeze this week with the 17 companies trading on the NYSE rallying nearly 20% in just three days. However, since May 1, 2008 this group is still down 24.8%. (Before this past week’s rocket ride, the group was down 37.2%.)
Not surprisingly given the government bailout plan announced this week, Fannie Mae and Freddie Mac enjoyed the biggest lift jumping 89.5% and 74.5% between July 15 and July 18. But as of the July 18 close, they were still down 61% and 72% in the last four months (since March 20).
In their monthly Short Interest Report on July 16, Bespoke Investment Group updated their short interest numbers showing that short interest as a percentage of the float continued to increase during the second half of June with the average short interest hitting 6% for the S&P 500.
Over the last year, short interest has increased 48% for the 500 stocks. Bespoke also found that the 10 percent of stocks in the S&P 1500 with the highest short interest (150 stocks) gained 15.1% in the two day period ending July 17, 2008 compared to just 2.2% for the 150 stocks with the lowest short interest. Now that’s a short squeeze rally!
Figure 2 – Chart showing three-day stock performance for 17 of the 19 stocks that the SEC identified in its naked-short prohibition order amendment to the Regulation Short Sale (RegSHO) rules Tuesday. Two of the companies trade on the pink sheets so we graphed the other 17 that trade on the NYSE. As a group, these stocks jumped nearly 20% in the recent three-day period! Chart by VectorVest.com.
We checked Buyins.net, a website that tracks naked short selling statistics that became available as the result of RegSHO that became law on January 1, 2005. Buyins.net has to contend with a regular barrage of hack attacks presumably from short sellers who don’t like what they are doing.
We looked at their list of stocks that are fail to delivers [FTDs] (stocks shorted without first having to borrow the same number of shares, which is what you and I have to do before executing a short sale). At the top of the list is Medis Technologies, which has remained on the SEC’s fail to deliver threshold list for 742 days.
In other words, it has been the target of naked short attacks and these shorts have not had to deliver shares that they have shorted for a total of 742 days! We counted a total of 244 stocks that have stocks that are classified as fail to delivers in excess of the maximum supposedly allowed by the SEC of 13 days.
Brokers, market makers and some other big players have found ways around this inconvenient rule. Brokers and money-makers should have some time to deliver borrows, but 742 days?! There is something seriously wrong in stock regulation/enforcement land and as long as it is allowed to continue, stock markets will experience increased short-driven volatility.
Ilargi: NYT’s Gretchen Morgensohn has far too little consistency in the quality of her articles. yet, this one is good, or at least touches on a topic worthy of discussing. While I would never incite societal unrest, or even predict it, I do think that the rich in America are wrong in their assessment of what they can get away with. When in a year or two, the people have finally figured out what crimes were perpetrated today, simply by experiencing a deeply lowered standard of living, if not outright destitution, will they take it all lying down? Answer me this then: why would they?
Borrowers and Bankers: A Great Divide
The credit crisis has exposed and worsened a dangerous and deepening divide in this country between a vast number of average borrowers and a fairly elite slice of corporations, banks and executives enriched by the mortgage mania.
Borrowers who are in trouble on their mortgages have seen their government move slowly — or not all — to help them. But banks and the executives who ran them are quickly deemed worthy of taxpayer bailouts. On the ground, this translates into millions of troubled borrowers, left to work through their problems with understaffed, sometimes adversarial loan servicing companies. If they get nowhere, they lose their homes.
Taxpayers, meanwhile, are asked to stand by with money to inject into Fannie Mae and Freddie Mac, the government-sponsored mortgage finance giants, should they need propping up if loan losses balloon. The message in this disconnect couldn’t be clearer. Borrowers should shoulder the consequences of signing loan documents they didn’t understand, but with punishing terms that quickly made the loans unaffordable.
But for executives and directors of the big companies who financed these loans, who grew wealthy while the getting was good, the taxpayer is coming to the rescue. To be sure, bailouts are becoming increasingly necessary in our highly leveraged, interconnected financial world. One obvious reason that huge companies are not allowed to fail is that so many people are hurt by such debacles.
If a family files for bankruptcy or loses a home, the pain still hurts, but its emotional and financial ripples are confined. And in the heat of a financial crisis, there is often little time to think through who deserves a bailout and who does not. In especially dire circumstances, leaders have no choice but to rescue companies.
Think about Bear Stearns: even though it was relatively small in size for a brokerage firm, its demise had to be averted because of a possible domino effect that might have also taken down its many trading partners. In that multibillion-dollar bailout, it was Bear’s big and wealthy counterparties who benefited.
Fannie Mae and Freddie Mac, however, present an exponentially larger problem. They are unquestionably too big to fail. With $5.2 trillion in mortgages either on their books or guaranteed by them, their bailout was completely predictable. If those companies had been left for road kill, the mortgage market would have ground to a halt and a financial conflagration of historic and devastating proportions would have resulted.
Not all big banks get bailouts, of course. IndyMac Bank, one of the nation’s largest savings and loans, was closed down by regulators last week. Nevertheless, we are in dangerous territory today where bailouts are concerned, and not only because they feed Americans’ suspicions that only the rich and powerful get help in our country.
Bailouts are also ticklish affairs because of the precarious state of our economy. As Americans are being asked to shore up reckless financial companies, they are also being punished by high oil prices, rocketing food costs and a stomach-churning slide in the buying power of their currency, the once-almighty dollar.
So asking Main Street to bail out Wall Street leads to this inevitable question: Weren’t the financial folks the ones who helped create the mess we’re in? Yet last week, regulators gave a nice boost to Wall Street and other members of the financial club.
Christopher Cox, the chairman of the Securities and Exchange Commission, devised an emergency rule change for traders wishing to sell short the shares of 19 financial companies, including Lehman Brothers, Merrill Lynch, Fannie Mae, Bank of America and Citigroup.
The rule states that if you haven’t borrowed the shares you intend to sell short, you can’t make the trade. It extends until July 29. There are several interesting aspects to this change. First, if the S.E.C. believes that shorting without previously borrowing shares is a problem in the market, why not apply the rule to all stocks?
After seeing many of the 19 companies’ stocks shoot higher after the plan was announced, executives at General Electric, the American International Group and MBIA, companies whose shares have also been pummeled in the financial crisis, must surely feel left out of the fun. Once again, this emergency action smacks of the regulatory responses of recent years: do nothing to curb the deal-making mania while it is occurring, but when the rout comes along, hurry up and rein it in.
Of course, people prefer rising stock prices to declining ones. Wouldn’t it be wonderful if shares never fell? But such actions call into question the claim that ours is a free-market system. More and more, our version of free markets holds that they are free only when asset values rise. When they fall, the markets must be managed.
HERE is a question: Might not the routs, which inevitably follow the manias, be less painful if things were not allowed to get wild and crazy on the upside? Might not the American people be better off with regulators who curb market enthusiasm — whether in the form of errant lending or voracious, ill-considered deal making — when it reaches manic levels, to protect against the free fall, and the bailouts, that ensue?
No, no, no — perish the thought, especially when the taxpayer is there to pick up the bill. Which returns us to the dispiriting divide between those who receive help and those who don’t. “The banks are too big to fail and the man in the street is too small to bail,” said John C. Bogle, the founder of the Vanguard Group, the mutual funds giant, who is a philosopher of finance.
Mr. Bogle is working on his seventh book, titled “Enough,” which is scheduled to be published in November. He said he was disturbed by the extreme speculation that spread into the entire economy during the housing boom and that now threatens both consumers and investors.
“I predicted last summer that this would be my 10th bear market,” he said. “But this one is different. The others were more marketlike, reflecting problems in the market, not problems in the society and the economy as this one does. As a result, we’re in for a much more troublesome era than after the other big bear markets.”
Banks Worried About EU Plans for Tighter Credit Rules
The European Commission intends to respond to the international financial crisis by imposing tougher rules on banks' operations. The financial sector is worried that the plans will restrict lending and make credit more expensive.
The European Union is ramping up the pressure on the financial sector with plans to tighten regulations under which European banks can invest in global credit markets, the Financial Times Deutschland reported on Monday.
The EU wants to only allow banks to buy so-called securitized loans -- loans repackaged as securities -- if the seller continues to hold 10 percent in his books, the newspaper reported, citing an internal European Commission draft for new bank equity capital rules. EU Internal Market Commissioner Charlie McCreevy wants to implement the rules in the autumn, the report said.
EU governments and the European Parliament have yet to approve the plan. The plan has alarmed the financial industry which fears it could restrict lending in Europe and drive up the price of fresh capital for companies, homebuyers and consumers. Europe's capital market is at risk of becoming over-regulated, bank representatives have warned.
They are also worried about EU plans to limit the size of loans one bank can grant to other banks. The draft plan envisages requiring banks to commit no more than a quarter of their equity capital for such loans. That could lead to new liquidity shortages in inter-bank dealings, financial sector associations are warning.
UK: interest rate cuts or deepening recession, hundreds of thousands of job losses
The British economy is falling into a recession that could be deep and painful if interest rates are not cut sharply right now, says Professor David Blanchflower, a member of the Bank of England's monetary policy committee (MPC).
Blanchflower, who spends half his time in the United States as an economics professor at Dartmouth College, thinks Britain could be in for a worse time than the US economy and needs to slash interest rates as the Federal Reserve has done over there. Hundreds of thousands of people are likely to lose their jobs, he thinks.
His warning comes days after the chancellor, Alistair Darling, acknowledged that the slowdown could be "profound" and as a leading economic thinktank, the Ernst & Young Item club, says in a report today that the outlook is like a "horror movie".
Blanchflower has been voting for interest rate cuts for the past nine months but appears frustrated that his eight MPC colleagues, including the Bank governor Mervyn King, have not shared his sense of urgency in wanting to support a deteriorating economy with easier monetary policy. He stresses he is not a doom-and-gloom merchant but is worried about what the economic data is pointing to.
"I think we are going into recession and we are probably in one right now," he said. "We will probably have three or four quarters of negative growth but the risks are to the downside. It's not too late to stop it but we have to act right now. Monetary policy has been far too tight for too long. We can't just sit and do nothing as we have done for too long."
He said he would like to see interest rates "well below" their current level but would not be specific. The MPC started cutting rates late last year, reducing them three times to the current 5%, with the last cut in April. But the other eight members did not follow Blanchflower in voting for further rate cuts in May and June, although the vote of the meeting earlier this month will not be known until Wednesday.
The others are concerned that inflation has risen sharply above its 2% target, driven by surging oil and food prices. They want to see further evidence that the economy is slowing, and thus dragging down inflation, before they act.
But Blanchflower wants them to look through what he calls the "short-term blip upward in inflation" and focus on the medium-term picture, which he thinks will mean inflation possibly going below 1% in 18 months' time.
"Our job is to focus on inflation in the medium term so we have to look through the short-term shock from oil and commodity prices," he said. "The economy is now slowing so fast we run the risk of writing a letter on the low side in the medium term." King is obliged to write to the chancellor if the inflation rate strays more than 1 percentage point above or below the 2% inflation target.
Blanchflower also said recent sharp falls in oil prices - to about $128 a barrel from the record of above $147 - could lead to lower inflation, noting that people were driving less. "We are now seeing a demand response," he said.
He dismissed fears that pay growth was about to take off as workers demand more in response to rising inflation.
"It is not the 1970s. We don't have the union power that we saw then and people are fearful of losing their jobs, so in my view there is no likelihood of wages taking off. I've been saying this for 18 months and I've been right." He pointed to slumping house prices and the credit crunch afflicting both the US and Britain, and said they were the "biggest economic problem since the Great Depression".
He said he was amazed that some City pundits had recently been thinking the MPC should raise interest rates in response to higher inflation. Blanchflower thinks the US authorities have taken timely action by slashing interest rates to 2% and cutting income tax. "The US has had a big stimulus but the UK has had none. So the same things that have been happening in the US will happen in the UK but they could well be worse," he said.
He thinks UK house prices, which were more inflated than in the US, will fall further, possibly by 30%. He also thinks that the recent rises in unemployment are just "the tip of the iceberg". He predicts that recent redundancies among housebuilders, combined with job losses in the City and retailing, will raise unemployment by one or two percentage points from the current 5.2%. That would mean hundreds of thousands of people losing their jobs.
UK economy heads for ‘horror movie’
Britain is facing an “economic horror movie” because of a “toxic mixture” of a moribund credit market and volatile oil prices, according to a leading forecasting group.
The Ernst & Young Item club, which uses the Treasury’s economic model, will argue in a report tomorrow that the economy will struggle to avoid recession. This comes as a survey by the Institute of Directors shows that business confidence has slumped to the lowest level ever recorded, with company chiefs increasingly gloomy about the investment climate.
These reports follow an interview with Alistair Darling in which the chancellor admitted the downturn would be more “profound” and last longer than he had expected. Also, Sir Win Bischoff, chairman of Citigroup, the American financial giant, believes that house prices in Britain and America will keep falling for another two years.
The Ernst & Young Item club predicts growth of only 1.5% this year, slowing to 1% in 2009. It says consumer spending will slow to a standstill, rising by only 0.2%, and forecasts a two-year drop in investment. It also warns that the chancellor’s budget strategy has been thrown into “turmoil” by the downturn and an unplanned £2.7 billion tax giveaway.
It predicts the budget deficit will top £50 billion and the “current” budget deficit, used to determine the golden rule, will remain in the red for at least the next three years. Peter Spencer, chief economist at the Item club, said: “Both on the high street and in the housing market it is going to get a great deal worse before it gets better. We have already seen a housing crisis that has morphed from a credit crunch to a general collapse in confidence as prices have tumbled.
“Our worry is that without the usual medication from the Bank of England - which would have nasty inflationary side-effects in this environment - consumers will follow suit, moving from their current state of denial into a state of despair.” Meanwhile, the Institute of Directors’ quarterly business opinion survey shows business optimism at its lowest level since the survey began in 1996. T
he proportion of company directors “more versus less” optimistic about their company’s prospects fell to -25%, compared with -17% three months ago. Two-thirds of bosses think their own business is still performing well, though this was down on 74% last time. Graeme Leach, chief economist at the institute, said that while the fall in business confidence was worrying, the survey’s results were mixed.
“Company directors seem to be saying we are doing okay at present but ask us again in three to six months and it could be hell out there,” he said. “There are real difficulties in interpreting business confidence at the moment because there is a record gap between actual performance and future perceptions.”
Among the more optimistic signs in the survey, a net 12% of firms plan to increase employment and a balance of 8% think profits will go up. Asked about their investment plans rather than the general climate, a net 11% planned a rise. There was also a small rise in pricing intentions, with a balance of 15% of firms intending rises, against 12% three months ago.
“The sharp fall in overall business optimism is very worrying and points towards a recession,” said Leach. “Other results in the survey suggest we can still escape with a sharp slowdown over 2008-9. The survey suggests the pressure on the corporate sector for a labour shake-out is muted. Whether this situation will hold is the key uncertainty.”
The credit crunch is forcing more businesses into difficulty, according to research by the insolvency specialist Begbies Traynor. It monitors the number of firms reporting “critical” problems - those facing winding-up petitions or more than £5,000 in county-court judgments against them. The figure ballooned in the second quarter to 4,258, nearly seven times more than in the same period last year.
UK forecaster says things can only get worse
The UK economy is heading for recession next year and unemployment could top two million by 2010. That's the gloomy prognosis from the Ernst & Young Item Club, which publishes its summer forecast tomorrow.
Peter Spencer, Ernst & Young's chief economist, said: "Both on the high street and in the housing market, it will get a great deal worse before it gets better." He added that the economy will struggle to avoid recession next year, with predicted GDP growth of only 1 per cent. "Our worry is that without the usual medication from the Bank of England, consumers will move from their current state of denial into a state of despair."
Ernst & Young's dismal forecast comes after Sir John Gieve, deputy governor of the Bank of England, warned that inflation is set to climb well over 4 per cent this year. He also admitted that a recession looks likely.
In a severe blow to Gordon Brown, the Treasury has been forced to admit it is working on plans to reform its fiscal rules on spending and debt as the Government will break its own rule limiting net public-sector debt to 40 per cent of national income.
But Mr Spencer said this profligacy was no surprise. "As we have consistently warned, both the consumer and the Government have been living beyond their means for the last few years, overborrowing on credit.
Households will be lucky to see real disposable income growth of 1 per cent this year. With repayments becoming more onerous, rising inflation and sharp reversals in the housing and equity markets, consumers are under increasing pressure."
The extent of the economic crisis was brought home again last week when 6,000 jobs were lost at Wolseley, the plumbing to building materials company, and 375 jobs were cut at Kier, the housebuilder. Mr Spencer said unemployment will rise but not at the rate of previous downturns. Immigration is falling, he added, which will lessen the impact of job losses.
Ilargi: I talked about England on Saturday, in less than rosy terms. One of the points I made concerned the problems British banks have in raising badly needed additional capital. This morning, it’s fair to say it’s only getting worse. HBOS is the no.1 mortgage lender in the UK, managed to sell only 8% and change of the new shares, even though they were dirt cheap.
Underwriters Morgan Stanley and Dresdner Bank are now stuck with the 91%+ of the shares. It’s the last thing these banks can use these days, but if they’d try to sell the shares, they would drive the price down, likely by a lot. Tails you lose, heads you’re dead. Needless to say, rights issues for UK banks are perilously close to death too.
HBOS investors take up less than 10% of rights issue
Banking giant HBOS revealed today that less than 10% of shareholders took part in its £4 billion rights issue. The group said just 8.29% of investors opted to buy heavily discounted shares as part of the scheme to help strengthen its balance sheet.
It potentially saddles the rights issue's underwriters, Morgan Stanley and Dresdner, with more than £3.6 billion worth of the new shares. The investment banks have the next two days to try to sell them at a profit, and will be forced to accept the stock themselves if they fail to do so. The low take-up means it is the worst corporate fundraising exercise since BP tried to raise £7 billion immediately after the stock market crash of 1987.
HBOS's attempt was launched back in April when HBOS's share price at the time was around the 500p mark. Shareholders were offered two shares at the knock-down price of 275p for every five held. But since then the bank's stock has plunged in value amid fears of further big write-downs in the sector and general economic gloom, severely dampening the appetite of investors to buy the new shares.
Shares in HBOS, which is Britain's biggest mortgage lender, actually went on to fall below the discounted rights issue price on several occasions ahead of last Friday's take-up deadline. Most of the group's estimated two million smaller investors, who were created when the Halifax Building Society demutualised in 1997 and own more than a quarter of the shares, will have turned their backs on the cash call.
HBOS will get its hands on the £4 billion as part of the underwriting deal. But if Morgan Stanley and Dresdner try to offload the stock on the market today and tomorrow, that could risk depressing the share price even more.
The 8% take-up rate for HBOS's rights issue is below the 19% achieved by Barclays for its recent £4.5 billion share placing. Barclays, whose share price has also been buffeted during recent stock market turmoil, said a series of wealthy Asian and Middle Eastern investment groups picked up the remainder of the shares.
Britain's major banks have had to ask shareholders for more money to bolster their finances after suffering some hefty writedowns thanks to the credit crunch. Last month HBOS said it had written off more than £1 billion this year.
Rival Royal Bank of Scotland raised £12 billion earlier this year, also through a rights issue. It was backed by more than 95% of investors, but unlike HBOS, RBS's shares remained comfortably above the discounted issue price.
HBOS spokesman Shane O'Riordain said the group had been realistic about the take-up of the rights issue. He said: "(It) has been conducted in the middle of a fierce financial storm. We have seen unprecedented volatility in banking stocks." But he added: "The bottom line is that we have raised £4 billion of capital.
"Just like ships need more ballast in heavy seas, banks need more capital in tougher times. We have now raised that capital." Mr O'Riordain said the bank would now have one of the strongest balance sheets of any bank in Europe thanks to the fundraising.
He added: "From our perspective, the key advantage of a rights issue is that all shareholders are treated in exactly the same way." HBOS shares opened more than 4% down today.
Bank lending lies at heart of UK recession risk
In the US the rate of growth of the money supply has collapsed but in the UK money supply appears to be growing strongly. Our leading money supply measure, M4, expanded by 11.5pc in the year to June.
But I wouldn't draw much comfort from this. Cutting away the mumbo-jumbo, the money supply is the ordinary deposit liabilities of banks - the amount that people like you and me, as well as companies and financial institutions, have in the bank. Movements in this total can be caused by all sorts of changes in the financial system. Accordingly, the numbers need interpretation.
In response to recent turmoil, banks have moved activities on to their balance sheet, which means they now have more explicit liabilities to be included in the money supply measure. Equally, they have outstanding lending commitments to a number of borrowers and in the most part they have honoured these.
As they have lent, so the recipients of the loans have deposited the money and so the money supply has expanded. And since many other sources of finance have closed, borrowers have turned to the banks for funding. Yet this will not necessarily continue.
In the recession stakes, as in so much else, the US is six months to a year ahead of us. The rate of money supply growth is probably set to slow here sharply as well. But does this matter? For some economists monetarism is a sort of religion. It provides easy explanations and comforting answers. And it is monotheistic, even though its deity appears in a number of different forms.
This religion exercises an iron grip over some of its devotees - although their number has fallen sharply over recent years. Is it set for a revival? Some of the Old Believers will now be jumping up and down with righteous indignation - and seeking converts.
I am not a believer, old or otherwise, but I often concur with the conclusions of those who are. My view is that the liability side of bank balance sheets is not particularly significant. I do not believe that the "moneyness" of bank liabilities makes them particularly special.
If people have the wealth but don't have the money they are generally able to make transactions by acquiring the readies, through borrowing or transferring other forms of assets. And the liquidity characteristics of different financial instruments are constantly changing - as you would expect in a vibrant, innovative economy.
This means that the appropriate definition of money is changing also, which makes fixing on one particular definition of the money supply a complete nightmare - as the Conservative government of the 1980s learned all too painfully. But this does not mean that financial activities do not matter for the real economy.
My view has always been that the significant bit of bank balance sheets is on the asset side. It is bank lending which really counts. I may not be a monetarist but I am a creditist. This may sound like splitting hairs, and the two approaches will often lead to the same conclusion because both sides of the balance sheet must move together. But money and credit aren't always in step, as some bank liabilities don't count as money and not all credit comes from the banks.[..]
What makes the current situation so much worse than other UK property downturns is that this one is the first to occur in a low inflation world. House prices fell by 32pc in real terms in the mid 1970s but because of rampant inflation this drop was achieved with hardly any fall in nominal prices. For banks this difference is critical, because bank liabilities are in nominal terms.
Whether a cutback in bank lending results in serious damage to the economy depends upon what the bank credit is financing. If it is financing financial activity, such as management buyouts, then the impact on aggregate demand may be minimal. Asset prices may be lower, and that would have some indirect impact on spending, but the direct connections would be weak.
By contrast, if it finances consumer spending or purchases of plant and machinery, or holdings of stocks, or covers running losses while businesses expand or cope with a downturn, then the real economic impact will be direct. The banking system is the engine of the economy. Never forget that the Great Depression in America was associated with a collapse of bank lending and the money supply.
Even non-monetarists should be watching the money and banking numbers like a hawk. And if the growth of bank credit slows substantially, let alone contracts, then you should be on guard for an even worse recession than currently looks likely.
Ilargi: As ever more people go hungry, and food and energy prices are forever stuck at levels unaffordable for them, yes, the moment is ideal for pushing through the door one more enormous Trojan thoroughbred of globalization.
Just when you think this is from the Middle Ages, and it can’t be true anymore in 2008, your representatives step it up a notch, enabled by the minimal press coverage and the increasing misery in the poor regions of the planet. It evokes the image of laying siege to a city: Open your markets to our farmers, or we’ll starve you.
'Now or never' World Bank chief urges on trade deal
World Bank President Robert Zoellick on Sunday urged trade ministers to push for a breakthrough in this week's World Trade Organization talks, saying it was "now or never" to reach a deal.
Zoellick said progress on agricultural issues in the meeting opening in Geneva on Monday would bolster confidence in a world economy strained by soaring food and energy prices and a financial crisis. "It has never been more important for WTO members to move forward on the Doha Development Agenda," he said in a statement before the talks, which will focus on tariff and subsidy cuts.
"It is now or never," said Zoellick, who as former U.S. trade representative helped launch the Doha trade round in 2001. He said an open and fair trading system would give farmers in developing countries a reason to expand production. Consumers would benefit from lower prices and governments could save on the costs of subsidies and improve their budgets.
Trade minister from dozens of countries will try to achieve to break the deadlock in the long-delayed Doha trade round. Developing countries are pushing rich nations to open their markets by cutting tariffs, arguing that trade distorting subsidies squeeze out farmers from poor countries. The outstanding issues in the agricultural and manufactured goods talks have been whittled down to about 30 from 200 in May.
"Both developing and developed economies stand to gain from lower barriers to goods and agriculture," Zoellick urged. "There are also great opportunities to expand trade among developing economies -- the so-called South-South trade, which is expanding rapidly," Zoellick said.
EU, US pressure emerging economies at WTO talks
The United States and European Union took aim at emerging economies at crucial WTO trade talks on Monday, warning them to open up their markets if the seven-year Doha Round is to succeed. EU Trade Commissioner Peter Mandelson even implied an ultimatum, saying he had gone out on a limb on agriculture and stressing that agreement was now conditional on developing countries making "real" cuts in industrial tariffs.
Mandelson, who is under strong political pressure, notably from France, to harden his stance on industrial issues, said: "They must be real. These cuts must provide some new market access in practice. "That is the political bottom line. Nothing else will work for us. Nothing else will close the deal."
The EU revealed it was prepared to go even further than hitherto on farm issues, offering to extend proposed cuts in its tariffs on farm produce to 60 percent from 54 percent. Earlier, Mandelson had said Europe was prepared to make "painful" cuts in its payments to farmers but only if it received guarantees of progress on other topics such as industrial tariffs and services.
"We are prepared to offer more than others in this round, but everyone must understand that we need something in return," he said. The EUs, offers, he warned "will not remain on the table indefinitely." Ministers from 35 key nations began critical talks under the aegis of the World Trade Organization here on Monday after seven years of confrontation and crisis.
US Trade Representative Susan Schwab called on emerging markets to play their part in the process. She highlighted the "fundamentally critical role" of the emerging markets to the Round, noting that much of the developing world itself did not have access to the rapidly emerging markets. "Seventy percent of the tariffs paid by developing countries are paid by other developing countries, they aren't paid by developed countries," she said.
The United States was prepared to make a contribution in return for contributions from emerging countries. The "vast overwhelming contribution" had to come through market liberalisation rather than subsidy cuts. The so-called Doha Development Round of negotiations was launched with great fanfare in the Qatari capital in November 2001.
It has been deadlocked as developed and developing countries show brinkmanship over concessions on issues such as agricultural subsidies and tariffs on industrial goods. Any draft agreement thrashed out here would then have to go before all 152 members of the World Trade Organization.
An already difficult situation was not helped over the weekend when a remark by a Brazilian minister, comparing the tactics of advanced countries to the methods of the Nazi propaganda chief Joseph Goebbels, sparked a row with Washington's representative. Celso made his contentious comment at a news conference on Saturday in response to claims by the industrialised countries that they had offered concessions on agricultural tariffs.
He said those claims reminded him of a remark by Nazi propaganda chief Joseph Goebbels that "if a lie is repeated enough times, it becomes the truth." On Monday, Schwab declined to respond further. She said there was a "sense of anticipation, a sense of momentum and a great desire to see a successful conclusion" to the Round.
Egyptian Trade and Industry Minister Rachid Mohamed Rachid also expressed optimism "because people expect nothing out of this week -- because when expectation is so low, people are becoming more relaxed to negotiate." Developing countries have been pressing for lower farm subsidies and agricultural tariffs in the developed world.
Industrialised states are demanding in return that developing countries make their markets more accessible to imported services and manufactured goods. WTO Director General Pascal Lamy of France argues a Doha deal could inject between 50 billion and 100 billion dollars each year into the world economy and be of enormous benefit to poor countries.
For the meeting to be a success, the WTO's 152 members will have to agree on "modalities" -- the key percentages for tariff cuts that would form the basis for any comprehensive deal. The Geneva talks have added urgency because all sides know that the United States will have a new administration and a new Congress next year.
End of illusions
There is a story about a science professor giving a public lecture on the solar system. An elderly lady interrupts to claim that, contrary to his assertions about gravity, the world travels through the universe on the back of a giant turtle. “But what supports the turtle?” retorts the professor. “You can’t trick me,” says the woman. “It’s turtles all the way down.”
The American financial system has started to look as logical as “turtles all the way down” this week. Only six months ago, politicians were counting on Fannie Mae and Freddie Mac, the country’s mortgage giants, to bolster the housing market by buying more mortgages. Now the rescuers themselves have needed rescuing.
After a headlong plunge in the two firms’ share prices, Hank Paulson, the treasury secretary, felt obliged to make an emergency announcement on July 13th. He will seek Congress’s approval for extending the Treasury’s credit lines to the pair and even buying their shares if necessary. Separately, the Federal Reserve said Fannie and Freddie could get financing at its discount window, a privilege previously available only to banks.
The absurdity of this situation was highlighted by the way the discount window works. The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.
Absurd or not, the rescue package notched up one immediate success. Freddie Mac was able to raise $3 billion in short-term finance on July 14th. But the deal did little to help the share price of either company or indeed of banks, where sentiment was dented by the collapse of IndyMac, a mortgage lender.
The next day Moody’s, a rating agency, downgraded both the financial strength and the preferred stock of Fannie and Freddie, making a capital-raising exercise look even more difficult. As a sign of its concern, the Securities and Exchange Commission, America’s leading financial regulator, weighed in with rules restricting the short-selling of shares in Fannie and Freddie.
The whole affair has raised questions about the giant twins. They were set up to provide liquidity for the housing market by buying mortgages from the banks. They repackaged these loans and used them as collateral for bonds called mortgage-backed securities; they guaranteed buyers of those securities against default.
This model was based on the ability of investors to see through one illusion and boosted by their willingness to believe in another. The illusion that investors saw through was the official line that debt issued by Fannie and Freddie was not backed by the government. No one believed this. Investors felt that the government would not let Fannie and Freddie fail; they have just been proved right.
The belief in the implicit government guarantee allowed the pair to borrow cheaply. This made their model work. They could earn more on the mortgages they bought than they paid to raise money in the markets. Had Fannie and Freddie been hedge funds, this strategy would have been known as a “carry trade”.
It also allowed Fannie and Freddie to operate with tiny amounts of capital. The two groups had core capital (as defined by their regulator) of $83.2 billion at the end of 2007; this supported around $5.2 trillion of debt and guarantees, a gearing ratio of 65 to one. According to CreditSights, a research group, Fannie and Freddie were counterparties in $2.3 trillion-worth of derivative transactions, related to their hedging activities.
There is no way a private bank would be allowed to have such a highly geared balance sheet, nor would it qualify for the highest AAA credit rating. In a speech to Congress in 2004, Alan Greenspan, then the chairman of the Fed, said: “Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.” The likelihood of “extraordinary support” from the government is cited by Standard & Poor’s (S&P), a rating agency, in explaining its rating of the firms’ debt.
The illusion investors fell for was the idea that American house prices would not fall across the country. This bolstered the twins’ creditworthiness. Although the two organisations have suffered from regional busts in the past, house prices have not fallen nationally on an annual basis since Fannie was founded in 1938. Investors have got quite a bit of protection against a housing bust because of the type of deals that Fannie and Freddie guaranteed.
The duo focused on mortgages to borrowers with good credit scores and the wherewithal to put down a deposit. This was not subprime lending. Howard Shapiro, an analyst at Fox-Pitt, an investment bank, says the pair’s average loan-to-value ratio at the end of 2007 was 68%; in other words, they could survive a 30% fall in house prices.
So far, declared losses on their core portfolios have indeed been small by the standards of many others; in 2008, they are likely to be between 0.1% and 0.2% of assets, according to S&P. Of course, this strategy only raises another question. Why does America need government-sponsored bodies to back the type of mortgages that were most likely to be repaid? It looks as if their core business is a solution to a non-existent problem.
However, Fannie and Freddie did not stick to their knitting. In the late 1990s they moved heavily into another area: buying mortgage-backed securities issued by others. Again, this was a version of the carry trade: they used their cheap financing to buy higher-yielding assets. In 1998 Freddie owned $25 billion of other securities, according to a report by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO); by the end of 2007 it had $267 billion.
Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion at the end of 2007. Although they tended to buy AAA-rated paper, that designation is not as reliable as it used to be, as the credit crunch has shown. Sometimes the mortgage companies were buying each other’s debt: turtles propping each other up. Although this boosted short-term profits, it did not seem to be part of the duo’s original mission. As Mr Greenspan remarked, these purchases “do not appear needed to supply mortgage market liquidity or to enhance capital markets in the United States”.
Joshua Rosner, an analyst at Graham Fisher, a research firm, who was one of the first to identify the problems in the mortgage market in early 2007, reckons Fannie and Freddie were buying 50% of all “private-label” mortgage-backed securities in some years—that is, those issued by conventional mortgage lenders. This left them exposed to the very subprime assets they were meant to avoid. Although that exposure was small compared with their portfolios, it could have a big impact because they have so little equity as a cushion.
Both companies make a distinction between losses on trading assets (which they take as a hit against profits) and on “available-for-sale” securities which they hold for the longer term and disregard, if they think the losses are temporary. At the end of 2007, according to OFHEO, Fannie had pre-tax losses of this type of $4.8 billion; Freddie’s amounted to $15 billion.
The companies have also been unwilling to accept the pain of market prices in acknowledging delinquent loans. When borrowers fail to keep up payments on mortgages in the pool that supports asset-backed loans, Fannie and Freddie must buy back the loan. But that requires an immediate write-off at a time when the market prices of asset-backed loans are depressed. Instead, the twins sometimes pay the interest into the pool to keep the loans afloat. In Mr Rosner’s view, this merely pushes the losses into the future.
Adding to the complexity is the need for both Fannie and Freddie to insure their portfolios against interest-rate risk—in particular, the danger that borrowers may pay back their loans early, if interest rates fall, leaving the companies with money to reinvest at a lower rate. This risk caused the duo to take huge positions in the derivatives market, and was at the centre of an accounting scandal earlier this decade.
In addition, Fannie and Freddie have bought insurance against borrower defaults when the homebuyer lacks a 20% deposit. But the finances of the mortgage insurers do not look that healthy, which may mean the risk ends up back with the siblings. Just as the rescuers need rescuing, so the insurers may need insuring. None of these practices seemed to dent the confidence of OFHEO in its charges. The regulator said as recently as July 10th that both Fannie and Freddie had enough capital. Indeed, their capital-adequacy requirement was reduced earlier this year so that they could make more of an effort to bolster the housing market.
By its own measure, OFHEO was right. At the end of the first quarter, the two companies exceeded their minimum capital requirements by $11 billion apiece, according to CreditSights. To fall to the “critical level”, which would require OFHEO to take the agencies into “conservatorship” (a fancy word for nationalisation), CreditSights says Fannie would have to lose $16 billion of capital and Freddie $14 billion. And because neither Fannie nor Freddie has depositors, there is no danger of their suffering a run, as Northern Rock, a British bank, did last year.
So why the crisis? Given the gearing in the businesses, things only need to go slightly wrong for there to be a big problem. Freddie lost $3.5 billion in 2007; Fannie reported a $2.2 billion loss in the first quarter, having lost $2.05 billion last year. Each had credit-related write-downs of between $5 billion and $6 billion last year. On a fair-value basis, which assumes that all assets and liabilities are realised immediately, Freddie had negative net worth of $5.2 billion at the end of the first quarter.
Clearly, if the pair continue to lose money for much longer, their capital base will be eroded. And, of course, Congress wanted their businesses to expand—meaning that more, not less, capital would be needed. That would require shareholders to stump up more money. But investors tend to anticipate a big equity-raising by selling the shares, and a falling share price makes an equity issue less likely. The fall was sufficiently speedy in mid-July to prompt Mr Paulson to step in. The stockmarket had called the government’s bluff.
The rescue package may have reassured the creditors but it did not stop the share price of either Fannie or Freddie from falling. After all, the government is likely to extract a heavy penalty from shareholders in return for its support (creditors are another matter, especially as a lot of GSE paper is held by foreign central banks).
Nevertheless the hope is that, if confidence can be restored, Fannie and Freddie can survive without raising capital until market conditions improve. In the short term, as the success of the debt issue on July 14th showed, they should be able to go about their business. The authorities are keen to avoid nationalisation, which would bring the whole of Fannie’s and Freddie’s debt onto the federal government’s balance sheet. In terms of book-keeping this would almost double the public debt, but that is rather misleading.
It would hardly be like issuing $5.2 trillion of new Treasury bonds, because Fannie’s and Freddie’s debt is backed by real assets. Nevertheless, the fear that the taxpayer may have to absorb the GSEs’ debt pushed Treasury bond yields higher. That suggests yet another irony; the debt of the GSEs has been trading as if it were guaranteed by the American government, but the debt of the government was not trading as if Uncle Sam had guaranteed that of the GSEs.
If Congress approves this package, the Fed will have more authority over the agencies. But that will give the central bank another headache. If an institution is struggling, the normal answer is to shrink its activities and wind it down slowly. But that is the last thing that the housing market needs right now. With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January.
So they will need to keep lending. Nor is there scope to offload their portfolios of mortgage-backed securities, given that there are scarcely any buyers of such debt. And if the Fed has to worry about safeguarding Fannie and Freddie, can it afford to raise interest rates to combat inflation? American monetary policy may be constrained.
The GSEs are not the only liability for the government. IndyMac’s recent collapse is the latest call on the Federal Deposit Insurance Corporation (FDIC). The FDIC has some $53 billion of assets, so it is better funded than most deposit-insurance schemes. But if enough banks got into trouble, the government would be on the hook for any shortfall. The same is true of the Pension Benefit Guaranty Corporation, which insures private sector benefits, but is already $14 billion in deficit.
In the end, the turtle at the bottom of the pile is the American taxpayer. But that suggests that, if Americans are losing money on their houses, pensions or bank accounts, the right answer is to tax them to pay for it. Perhaps it is no surprise that traders in the credit-default swaps market have recently made bets on the unthinkable: that America may default on its debt.