posted September 4, 2008
Fannie Mae, Freddie Mac and Phase Two of Financial Crisis

‘Fannie Mae, Freddie Mac, and Phase Two of Financial Crisis’
copyright 2008
by Dr. Jack Rasmus

Despite repeated efforts of the past year by the Federal Reserve Bank (FED), the U.S. Treasury, regulatory agencies, and global central banks, the current financial crisis has not been contained—let alone resolved. In the intervening months since the Bear Stearns investment bank bailout in March 2008 by the Federal Reserve, the instability of the U.S. financial system has instead continued to progressively deteriorate.

This past July 2008 a second major financial instability event—potentially of even greater significance and impact than last March’s Bear Stearns bailout—occurred: the near collapse of the two quasi-government housing market agencies, Fannie Mae and Freddie Mac. That near collapse, and the subsequent proposed bailout of the two agencies, marks yet another major milestone in the continuing deterioration of U.S. financial institutions.

Like Bear Stearns before, the collapse of Fannie/Freddie was barely averted by an announcement by Federal Reserve Bank (FED) chairman, Ben Bernanke, and U.S. Treasury Secretary, Henry Paulson, that the government would bailout of the two agencies. Unlike Bear Stearns, the bailout will require Congressional action and its estimated cost may ranged as high as $300 billion, according to independent estimates. That’s nearly ten times the $29 billion bailout cost of Bear Stearns.

Origins and Evolution of the Fannie/Freddie Collapse

It is oft-noted in the business press that Fannie/Freddie are liable for more than $5.3 trillion of total mortgage debt outstanding, or roughly half of total mortgage debt in the U.S. which totaled $10.6 trillion as of the end of March 2008, according to the U.S. Federal Reserve’s ‘Flow of Funds’ data. Less often noted is that same mortgage debt ballooned since 2001 from $4.8 trillion to that $10.6 trillion! That’s an increase of approximately $6 trillion dollars in just seven years. Between 2003-06 alone mortgage debt recorded a net growth of more than $1 trillion a year in each of those four years! Nearly half of that was ‘bad’ subprime mortgage debt.

To get an idea of just how much $6 trillion is, imagine a stack of $500 bills piled more than 840 miles high. That’s a stack, laid on its side, end to end, longer than the distance from New York City to Chicago.

While banks and mortgage companies reaped the super-profits from multi-trillion mortgage lending during the four consecutive years, 2003-2006, they simultaneously pushed with lobbyists and Bush administration contacts for the full privatization of Fannie/Freddie. They were not able to achieve that, but were able to keep Fannie/Freddie under-funded in the meantime and freeze the latter’s share of mortgages purchased at no more than 40% of the total mortgage market.

But once the subprime mortgage bust began in late 2006, the same banking and mortgage lenders sought to have Fannie/Freddie buy up their bad debt in greater and greater volumes, including their so-called ‘securitized’ packages that were full of bad subprime mortgages. Fannie/Freddie’s bad debt load quickly accelerated. Its share of the mortgage debt market in turn rose rapidly, from less than 40% in 2005 to more than 70%. By the first quarter of 2008, more than 80% of all mortgages issued were purchased or guaranteed by Fannie/Freddie.

Fannie/Freddie’s debt load rose quickly in recent years as banks/mortgage lenders unloaded their bad debt on them. But their funding and reserves on hand to cover the debt did not. By summer 2008 the agencies found themselves with more than $5 trillion in liabilities, of which $1.7 trillion was direct debt, but with only $81 billion in reserves. That meant reserves equal to only 1.6% of the mortgage liabilities they own or guarantee.

Created in 1938 to rescue homeowners and mortgages from an earlier similar bout of banking speculation gone bust, in 1968 Fannie/Freddie were partly ‘privatized’. That means they were no longer a purely government agency but from that point became corporations in which private investors purchased stock. Their private investors range from other financial institutions, wealthy independent investors, private equity funds, hedge funds, pension funds, and various foreign banks and institutions. Fannie/Freddie’s directly liable debt (called agency debt) of $1.7 trillion (of the total $5.3 trillion) is especially heavily owned by foreign central banks.

Should Fannie/Freddie collapse, their investors would suffer major financial losses as well as possible defaults and bankruptcies of their own. Foreign central banks would be especially hard hit. That would mean spreading and deepening the financial crisis further, not only in the U.S. but globally. It was much the same situation and fear of a global spreading of the crisis that provoked the Bear Stearns bailout. Only now potentially larger—much larger.

Like any other corporation and its investors, as it became increasingly apparent Fannie/Freddie were taking on more and more ‘bad’ debt investors became more concerned the two agencies could not cover their multi-trillion dollar liabilities with their miniscule liquid funds on hand. With housing prices continuing to fall and foreclosures rise, in early July analysts estimated losses by Fannie/Freddie over the coming year ranging from $100 to $300 billion depending on how far housing prices actually might fall over the coming year. With their ratio of available funds to debt and expected near term losses, investors did what most investors in any company do in such circumstances—i.e. they began a wholesale dumping their Fannie/Freddie stock. The break came on Friday, July 11, as Fannie/Freddie stock prices plummeted by 50%.

Fannie/Freddie’s reserves have continued to decline over the course of the current financial crisis, and in particular throughout the first half of 2008. Amazingly, instead of taking action to require an increase in their reserves, U.S. government regulators repeatedly eased the amount of funds the agencies were required to keep on hand to cover emergencies such as that which occurred in July. From 30% at the outset of 2008, required reserves were reduced by regulators to 20% and then to only 15%, with talk of a further cut to only 10% in September 2008 on the agenda.

An opportunity to do something about the situation arose in mid-May, in the form of proposed legislation for housing assistance for homeowners facing foreclosure. But Congress did nothing. Instead, it simply accepted promises that Fannie/Freddie would voluntarily raise capital to add to their reserves. Even tepid proposals to change the agencies’ regulators—a kind of ‘rearranging of deck chairs on the Titanic’—failed to pass Congress last spring.

In the days immediately leading up to July 11, government regulators, the FED and the Treasury repeatedly proclaimed that the two agencies had sufficient capital, were voluntarily raising more, and that no rescue of the agencies was necessary. Of course, Paulson-Bernanke never bothered to explain how companies with such a collapse in stock prices might be able to ‘raise capital’ and thus avert the crisis. Even before the near collapse of the two agencies this past July, both agencies together were jointly able to raise only $20 billion on their own. With projected losses between $100 to $300 billion coming, it is not surprising investors began taking what was left of their money out of them instead of investing more in them. Stock prices of both agencies continued to decline in June and into July. By the end of the week of July 7-11, Fannie Mae’s stock price was down 76% over the previous year, and Freddie’s had fallen 83%.

Over the weekend of July 12-13, however, Paulson, Bernanke of the FED, and regulators did another about-face, much like that which occurred following the Bear Stearns crisis over the weekend of March 15-16. (They thus appear to be developing a habit of working these reversals of policies on weekends). When markets opened on Monday, July 14, the Paulson-Bernanke duo announced a plan that guaranteed the government would not allow Fannie/Freddie to fail. The plan required neither the FED nor the Treasury directly fund the bailout (neither had sufficient funds in any event), but that Congress would be asked to provide the bailout funding. Until such funds were forthcoming, however, the FED would provide interim emergency loans to the two agencies from its ‘discount’ window and special auction it was using to prop up the investment banks since March. Paulson also proposed the U.S. Treasury buy the two agencies’ public stock, thus propping up their stock prices, if necessary

The moribund Housing bill unable to pass Congress was quickly resurrected following July 14. The Bush administration also proposed to repopulate the boards of directors of the two agencies with more Wall St. bankers. And Paulson-Bernanke made public assurances that ‘all necessary lines of credit’ would be open to the agencies until more substantial and permanent funding would be provided by Congress. The Congressional bill that was eventually passed by Congress in late July ultimately provided for a $300 billion line of credit—i.e. just about what is projected by analysts to date as the total losses of the two companies over the next period. The $300 billion is to be disbursed by the Treasury to Fannie/Freddie as needed as their losses rise, either as loans or as government direct purchases of the companies’ stock.

Despite the bailout announcement, a further general fall in the New York stock market and a further crisis in confidence in the banking system and financial institutions followed. The continuing crisis in confidence in financial institutions in general quickly spread following the bailout announcement to U.S. regional. The California bank, IndyMac, failed soon after, and stock prices of other regionals like WaMu, National City and others significantly declined. The Standard & Poor’s 500 bank stock index suffered its worst decline since created in 1989. Many banks and mortgage lending companies now teeter on the edge of the default abyss and bankruptcy. So much for the bailout announcement’s impact on general banking confidence!

The Strategic Significance of Fannie/Freddie

The near collapse and proposed bailout of Fannie/Freddie represents several important developments in the evolution of the current financial crisis. First, as noted previously, it means the current financial crisis has not only NOT been stabilized, but is actually getting worse. According to Bill Gross, manager of PIMCO, the world’s biggest bond fund, falling U.S. home prices will require financial institutions to write off more than $1 trillion in losses. The two to three million projected foreclosures may even be larger, given the estimated 25 million households whose homes are now in ‘negative equity’—i.e. worth less than they were purchased for and the remaining mortgage costs.

It also means that the U.S. central monetary authority, the FED, is not able to deal with the crisis any longer on its own—as it essentially did with Bear Stearns; it has now clearly ‘passed the buck’ to Congress to provide the even greater bailout funding. How much more the cost of bailout? According to a Standard & Poor’s estimate in early July, the cost would run somewhere between $420 billion and $1.1 trillion. That compares to the last housing market bailout that occurred in the late 1980s with the Savings & Loan debacle or around $250 billion.

As described in previous articles, the FED has committed to date more than $400 billion or its roughly $800 billion funds to bail out Bear Stearns and prevent the collapse of other banks in the U.S. and abroad. In July it extended prior deadlines to provide special funding to banks and financial institutions still in trouble into 2009, and it will no doubt have to extend that guarantee beyond as the crisis deepens.

The FED has also lowered interest rates as far as it believes it can, to 2%. Its policy of engineering short term interest rate reductions has clearly failed. Lowering rates has not generated a recovery in the real economy; nor has it even assisted bank lending much. Banks continue to be reluctant to lend to each other, let alone to other non bank businesses or homeowners. All that lower FED interest rates have accomplished is to fuel the devaluation of the dollar, feed currency speculators preying upon that devaluation, raise all types of commodity prices in the U.S., and in effect ‘export’ part of the U.S. slowdown to other economies in the process

The FED is therefore not about to commit what funding it has left nor lower rates further. Thus, the burden for bailing out the financial system has now shifted to the U.S. Treasury and Congress. This is an important shift in capitalist financial strategy for dealing with the crisis. It means monetary (FED) solutions to the financial crisis have been effectively neutralized, put on hold, for the next phase of the financial crisis.

Fannie/Freddie thus represent the shift into the second phase of financial crisis. Bear Stearns represented the end of the first phase of the crisis—or ‘end of the beginning’—of the financial crisis. Fannie/Freddie represents the ending the interim, or ‘hiatus’, period—from the Bear Stearns bailout in March 2008 to the Fannie/Freddie eruption in July 2008.

They also represent a strategic crossroads. It is clear the Fannie/Freddie bailout is inevitable so long as housing prices continue to drop, which they will, foreclosures continue to rise, and housing market losses continue to grow. Having fallen approximately 20% thus far, housing prices have at least another 20% to go. More than two million more foreclosures are projected. And losses by banks, although largely kept purposely opaque by banks and government alike from the public, continue to rise. Bailout is thus a foregone conclusion. No less foregone a conclusion is that bailout will now be at the direct, immediate expense of taxpayers—unlike Bear Stearns and just like the Savings & Loan crisis in the 1980s. Only this time it will be many times more costly than that former event.

It remains to be seen how successful a proposed future bailout by Congress and the Treasury will be in stabilizing the two agencies. Should the bailout be delayed as a result of election year politics, investors may once again begin dumping their stock at ever lower prices. It is also uncertain what the effects of a renewed crisis for Fannie/Freddie will mean for the housing market itself. It could contribute significantly to a further fall in prices in housing markets. That would produce a ‘feedback effect’ causing much greater losses at the agencies, requiring in turn even greater bailout funding. The agencies might thereafter be forced to sell assets at firesale prices. This very same development began occurring at the end of July among investment and commercial banks also unable to raise capital to cover losses. The hybrid giant bank, Merrill Lynch, in particular began firesales of its assets at the end of the month, dumping $31 billion in bad loans and mortgages for only $7 billion—a move almost certain to be copied by other banks. Should other banks follow Merrill-Lynch, Fannie/Freddie would not be able to avoid similar action. Losses would then grow further, stock prices fall, and bailout costs rise additionally.

The near collapse, and subsequent bailout, of Fannie/Freddie also marked the entry of the stock markets into clear ‘bear’ territory, in the U.S. and globally. Stock, or what’s called ‘equity’, prices have now crossed a threshold. Despite occasional recoveries, they will now also proceed to decline further. In even ‘normal’ or typical postwar recessions, stock prices have fallen between 30%-40% and the current recession is anything but ‘normal’. Time will likely show that the maturation of the Fannie/Freddie crisis in July 2008 was the ‘push’ that precipitated a further slide in the equity markets as well. The implications of the latter for a continuation of the general financial crisis are noted below.

But perhaps one of the more important strategic representations of Fannie/Freddie, and one of the least understood, are their tie-in to global derivatives markets. There are three critical numbers associated with Fannie/Freddie. First is their total liability of more than $5.3 trillion in mortgage debt. Second, and of more immediate concern, is their combined direct so-called ‘agency debt’ of $1.7 trillion (which is part of that $5.3 trillion total). Third is the more than $2 trillion in derivatives they own which were taken on to hedge their risks in their mortgage portfolio. The derivatives positions connect them to countless (and mostly unknown) global financial institutions. Were Fannie/Freddie to default or go bankrupt on their direct agency debt, the global impact via the derivatives market would be enormous. The magnitude of the current financial crisis would grow severalfold. It was much the same derivatives connection, by the way, that was also the most fundamental underlying concern precipitating the bailout of the Bear Stearns investment bank in March 2008. Thus both Bear Stearns and Fannie/Freddie represent critical bailout events initiated in order to prevent a collapse of the global, $60 trillion plus credit derivatives market.

‘Nationalizing’ the Housing Market?

At this point in the general financial crisis, bailout means the government must get more deeply involved in funding residential housing markets than ever before. Of course, banks and financial institutions don’t like that idea at all. That dislike is what lay behind their growing opposition to Fannie/Freddie during the boom times of 2002-06 and their drive to fully privatize the agencies at that time. But privatization is now clearly off the table, while bailout and deeper regulation are at the top. Bailout and re-regulation, on the other hand, raise the fundamental question whether private lenders need even be involved at all in financing the housing market—or whether the housing markets should in effect be ‘nationalized’.

Of course, ‘nationalization’ to capitalist financial interests is a stopgap measure designed to temporarily refloat the markets and institutions at taxpayer expense. After they are again financially stable, the idea is to resell them back again to private interests after they can make a profit once more. It’s the basic capitalist strategy of ‘socialize the costs’ and ‘privatize the gains’, which is the essential capitalist definition of ‘nationalization’. Even the Wall St. Journal editorialists now advocate that particular definition, arguing the current arrangements represent a ‘dishonest kind of socialism’. Instead, they propose nationalizing Fannie/Freddie in “a more honest form of socialism?. That formula for nationalization is essentially what ex-FED chairman, Alan Greenspan, has recently proposed: Take them over, re-stabilizing them at direct taxpayer expense. Then spin them off into six or seven private finance companies once again.

Despite Greenspan and business press pundits raising the capitalist version of nationalization, the idea of a different kind of nationalization is logically now possible—at it becomes increasingly clear that private financial institutions are the core cause of the crisis and that the only ‘game in town’ to keep things going is government direct control of financing the housing markets.

Fannie/Freddie, Debt-Deflation, and Epic Recession

The financial-banking system and the non-financial economy—both in the U.S. and abroad—has continued to worsen and not improve. The key question is why? Why has the financial system continued to deteriorate? And the real economy slip further into recession in its wake? Why, after U.S. monetary and political authorities thought they had brought the financial and banking system under some semblance of control after March 2008, was there a second financial blow up with the near collapse of Fannie Mae and Freddie Mac in July 2008—revealing that financial system and real economy are still becoming more unstable?

The key to understanding today’s continuing financial instability, and why there will be more ‘Bear Stearns’, ‘Fannie Maes/Freddie Macs’, as well as more financial institution bankruptcies in the months ahead, is the role Prices play in the process. Both rising prices (inflation) and falling prices (deflation). It is deflation in particular that is the prime cause of today’s continuing financial instability. On the other hand, it is inflation, or rising prices, that provoke the financial instability and deflation in the first place. What unites the two apparent contradictory developments—i.e. inflation and deflation—is rampant speculation investing that has been plaguing the U.S. economy for some time.

The U.S. economy has been experiencing a rising tide of massive speculative investment activity since the 1980s. Speculative investment has been growing in both its weight and mix as a percentage of total investment in the economy. Speculative investment feeds off of, and simultaneously drives up, prices for financial and other assets. The most notable example today is what is now happening with commodity price inflation. But before commodity speculation and inflation it was the housing price inflation and bubble of 2002-06. Before that the technology stock speculation and price bubble. And before that other asset price bubbles in the 1980s and 1990s. Speculative asset price bubbles lead inevitably to speculative asset price busts—i.e. deflation. Thus, the housing bubble of 2002-06 led inevitably to the housing bust. Just as today’s speculative commodity price bubble will inevitably lead to a price bust—i.e. yet another deflationary event.

The problem with deflation is that it leads to continuing and often severe financial losses. If prices continue to fall, then losses continue to rise. And what’s been happening with banks and financial institutions in the U.S. over the past year is that housing and other asset prices have continued to fall faster than banks have been able to raise cash and funds from other sources to offset those losses.

So long as housing prices continue to fall in the U.S. the losses of banks and other financial institutions will continue to grow faster and larger. In turn, more banks and lenders will continue to fail. That is also precisely what has been happening, and will continue to happen, to Fannie/Freddie. For the bailout of Fannie/Freddie has not resolved in any way the more fundamental housing crisis. It has only temporarily staunched the bleeding, at that at significant taxpayer expense.

The crisis at Fannie/Freddie will continue to grow because housing prices will continue to fall at least another 20%. Foreclosures will continue to rise for some time, driving the housing price decline. The recent Housing Bill addresses only one tenth of the eventual foreclosures. The $300 billion to cover Fannie/Freddie losses provides less than a third of total estimated mortgage losses from all sources.

There is an even greater problem with falling prices in the housing market, however. Housing price deflation leads not only to credit contraction in the housing industry but that contraction has been spreading to other financial markets, which in turn has led to deflation and losses in those other markets as well. Thus we see today Banks with growing losses from housing responding with ‘firesales’ of their remaining assets—such as Merrill Lynch recent did and other banks will soon do. Their equity, or stock, prices then fall in turn—i.e. even more deflation.

The real danger develops when deflation in assets bleeds out of financial markets and into markets for every day products and services, and then to workers’ wages in turn (which are just ‘prices’ paid for labor). And signs are growing that deflation is now beginning to spill out from financial and other assets to everyday, non-asset products and services. Auto prices are now falling noticeably and auto wages are in freefall. Wages in airline and trucking are declining. States like California have announced plans to reduce wages of state employees to minimum levels. Commercial property prices are falling. Even prices for some lines of business equipment and consumer durable products are softening rapidly.

Companies across the board, not just banks and financial institutions, consequently now face rising costs due to commodity price inflation and simultaneous falling revenues due to the deepening recession. Their inevitable response will soon be mass layoffs, which are coming in the U.S. economy later in 2008 and into 2009. The entire process leads to what, in a previous issue of this publication, this writer has called ‘Epic Recession’—a recession unlike any that have previously occurred in the U.S. A recession that is of longer duration, potentially deeper, and increasingly global in character. Already numerous economies have recently begun following the U.S. into recession: The U.K., Ireland, Spain, Italy, Portugal, New Zealand have all clearly tipped into recession. Two of the world’s other top four economies, Japan and Germany, have officially now joined the downturn as well. The contraction has clearly begun to synchronize globally.

The ultimate driver of the entire process, however, is the unwinding of the excess $21.6 trillion in net new debt added to the U.S. economy since 2001 and the deflation that debt unwinding is now causing. Behind the debt-deflation dynamic, however, lies the growing imbalance of speculative investment in the U.S. that has building for decades, and the even more fundamental causes that have been driving that speculation in turn.

Jack Rasmus

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