Oscar Wilde once described the British aristocracy's peculiar predilection for
fox hunting as the "Unspeakable in pursuit of the Inedible". In today's world,
the ruling elites in most countries tend to focus their attention on saving
their respective financial sectors, with a view to ensuring systemic stability
even as idiosyncratic failures abound (see
The New Brahmins, Asia Times Online, March 29, 2008). Much like fox
hunting, where scores of hounds and teams of horsemen come back with a mangy
fox or two, pickings from financial sector rescues tend to be quite slim.
In the US since the middle of last year, various arms of the financial sector
have been progressively trimmed, starting with the
exotic structured investment vehicles (SIVs) then moving swiftly on to mortgage
servicers and providers, and spiralling merrily on to investment banks. Doubts
about various commercial banks that take deposits from the public have also
surfaced from time to time. All of these entities, though, are mere
intermediaries that originate risk and transfer them to other investors,
including overseas investors and more importantly, two large US financial firms
that absorb the interest and credit risk of millions of American households.
This week, the final chapter in the unravelling of US systemic leverage opened
with salvos on two most important government sponsored entities (GSEs)
operating in mortgages, namely Federal National Mortgage Association (Fannie
Mae) and Federal Home Loan Mortgage Corp. (Freddie Mac). These two financial
behemoths have between them about US$5 trillion of mortgage assets, owned or
guaranteed, in effect touching some 70% of all mortgages in the United States.
Even though these companies are sponsored by the US government, they operate as
publicly listed stocks. Looking at their combined stock market valuation of
less than $20 billion as of Thursday night (July 10) compared with their $5
trillion in assets shows them already to be in significant economic distress.
In contrast, US commercial banks such as Citibank, JP Morgan and Bank of
America have stock market capitalization of around 10% of their total assets,
even after the massive decline in stock prices this year. Of the $5 trillion,
roughly $1.6 trillion sits on the balance sheets of the two GSEs, with the rest
"off" balance sheet - and this is precisely where problems began.
As with most such panic situations these days, the first salvo was fired by an
equity analyst who on July 7 questioned the impact of a new accounting change
for the two agencies. The analysis of one of its financial brethren by Lehman
Brothers, itself a troubled investment bank (see
The gullible and the greedy, Asia Times Online, July 4, 2008, for my
comments about financial firms criticizing each other), set off a storm of
stock selling, with the two agencies' share prices falling some 18% on the day
alone. Interestingly, shares of Lehman are down around 22% in the past two days
alone, making the year to date decline 75%.
The rule change mentioned by Lehman that would hurt the two agencies was soon
enough postponed to a later date by the ever-accommodative accountants at the
Financial Accounting Standards Board (FASB), who after all do not want their
most important companies going bust for accounting reasons. The damage though
had already been done. In their roles as guarantors of mortgage debt originated
in the US, the activities of the two government agencies resembles reinsurers
such as MBIA whose solvency has also been severely questioned over the course
of this year.
As a quick explanation of the proposed rule change, FASB has pushed for greater
financial transparency in statements for all financial institutions by making
them consolidate liabilities that are currently not recorded on published
balance sheets due to the use of SIVs. Last year's problems with SIVs, along
with the losses of money market mutual funds and other investors with exposure
to short-term debt issued by those vehicles, was on account of a lack of
visibility on explicit and implicit support by sponsoring financial
institutions.
In pushing through the rule change intended for commercial banks, FASB may have
inadvertently set off problems for the two federal agencies, which guarantee
gargantuan amounts of bond issuance backed by mortgage debt. Such guaranteed
debt is held to the tune of hundreds of billions of dollars by central banks in
Asia and the Middle East, for example, which is the reason that concerns about
the two agencies quickly become a global problem.
This isn't the first time that the two agencies have run foul of accounting
changes. Events over the course of 2002-03 meant that their practices for
hedging interest rate risk were inconsistent with approved methodology, as
regulators found the two agencies to have indulged in excessive trading for
what was supposed to be pure hedging transactions.
The resulting move of financial derivative income directly to the income
statement saw the most significant earnings volatility associated with the two
agencies, necessitating extensive communications with major investors in Asia
about the problems. In that period, Asian investors ended up supporting the two
agencies, giving them a life line by purchasing new securities backed by the
agencies.
Poole and other comments
Once again proving the adage made popular by former Federal Reserve Board
chairman Paul Volcker that retired central bankers should neither be seen nor
heard, former Fed board member William Poole mentioned in a speech this week
that Fannie Mae and Freddie Mac were essentially insolvent.
While the argument for disbanding Fannie Mae and Freddie Mac has been made by
right-wing media in the US for a long time now on grounds of competitive
advantages bestowed by the close relationship with the US government, the
comments by Poole were of a different nature in that markets interpreted them
as concerns of a former central banker with indirect supervisory
responsibilities. As the agencies often represent the biggest counterparty
risks of many US banks, concerns of the former Fed member were seen as
important.
In their testimony to the House Financial Services Committee later in
the week, both Treasury Secretary Hank Paulson and Fed chairman Ben Bernanke
mentioned the difficulties being faced by the two agencies on account of the
declining credit quality of mortgage assets in general, contingent liabilities
as mentioned above and potential funding restrictions. While the US government
is clearly going to support the agencies, the question of moral hazard become
germane - after all, Paulson mentioned in the same testimony that some
financial firms should be allowed to go bust in the current crisis.
As events gathered pace, by this morning in New York (July 11), we should
expect some sort of official statement about the future of the agencies, as is
being suggested by the online versions of many US newspapers. Reacting to the
first set of headlines, Asian stock and credit markets rebounded strongly from
their weak levels, while the potential for the US government to take on greater
debt obligations pushed 10-year US Treasury yields higher by 6 basis points.
This last point, going to the very credit quality of the US government itself,
is significant. On the back of the Japanese financial crisis in the 1990s, the
government there absorbed the financial risk of its banking system over and
over again, eventually losing its own prime credit ratings - a stunning rebuke
for the world's largest creditor nation of that time.
Unlike Japan of that time, the US is running a massive fiscal deficit that
threatens to get worse with the recession even as Republicans demand more tax
cuts and other measures designed to make the problem worse. With bank after
bank in trouble, and an almost endless moral hazard net being thrown by a
feckless government, it appears likely that the much-vaunted triple A credit
rating of the US government could come under a cloud sooner rather than later.
This will be a fitting end to the decades of excess in that country. The time
to pay the piper has arrived, with a bang.
Note: Former Fed board member William Poole this month joined
Merk Investments as a senior economic advisor, the mutual fund company said on
July 1. Asia Times Online regularly publishes articles by Merk, including
a week
ahead commentary.
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