Page 2 of 2 Jaws close in on Bernanke
By Julian Delasantellis
underwritten by Fannie and Freddie. By early 2007, as the greed crescendo
peaked, Fannie and Freddie were underwriting a mere 40% of the US mortgage
market, down from over 60% earlier in the decade.
The rest, of course, is the grim history of the past two years. The subprime
market cracked, leading the holders of the CDSs connected with the subprime
obligations to start demanding their promised payment from the specialized CDS
private insurers, called "monolines". This essentially drove the monolines to
the brink of bankruptcy. The shutdown of the market for credit default
swaps is what lies at the heart of what we now call the credit crisis.
Even though they did not make many subprime mortgage loans, Fannie and Fannie
still fell victim to the age's greed and arrogance. On any cul-de-sac, in any
new housing development, the bankruptcy and forced foreclosure sales of the
homes with the subprime mortgages are forcing down the real estate values of
the rest of the homes, the ones underwritten by Fannie and Freddie, in the
neighborhood.
As the US real estate market staggered and buckled before finally breaking last
summer and autumn, some voices were raised advocating fighting the then
still-nascent crises with greater participation by Fannie and Freddie,
specifically, by allowing the two to buy more, and higher-priced, mortgages.
This could have nipped the problem in the bud, but back last year, Bush, still
the free markets' ever-trustworthy troubadour, informed one and all that he
would veto any legislation of that nature.
Bush saw the light (probably through feeling the heat that was being placed on
his party's election prospects this year), and included in last winter's
economic stimulus package a geographically limited, temporary increase in the
GSE's statutory loan limits, in certain high priced markets, to just under
US$730,000. Still, increased authority by Fannie and Freddie are key elements
of the mortgage relief rescue package promoted by Democrats Representative
Barney Frank and Senator Chris Dodd and now slogging through the Congress,
weighed down by Republican legislative legerdemain. Bush has not said one way
or another whether he will sign the bill should it reach his desk; every time
he implies he might veto the bill, you can just hear the whoosh of the darts
heading towards pictures of the president at John McCain's campaign
headquarters.
Current reports are indicating that the GSEs are now purchasing about 80% of
the new mortgages being made in the US. This is why the two's current financial
difficulties, symbolized by the roughly 90% falls in the stock values of both
Fannie and Freddie since last August, are so serious.
Governments rush in to rescue endangered financial institutions when they are
said to be "too big to fail"; if ever that was true, if ever the maxim had any
real applicability, surely, with essentially the entire US housing industry now
resting on the GSEs' shoulders, the US government cannot stand by disinterested
as they bleed to death.
On Sunday evening, the US Treasury Department and Federal Reserve came out with
a Fannie/Freddie rescue plan. President Bush was nowhere to be seen in this
initiative - the Wall Street Journal reported that there were still free-market
holdouts in the White House, apparently the last laissez-faire zealots left in
the bunker as reality's punishing howitzers zeroed in, that opposed the deal.
The initiative called for a temporary increase in what the GSEs could borrow
from the Treasury, as well as increased US government equity investments in
Fannie and Freddie stock. These will require authorization from Congress. For
its part, the Federal Reserve announced that, for the first time, it was
opening its emergency assistance facility, or discount window, designed for
member banks (which the GSEs are not - they're not really "banks" at all) to
the endangered pair.
Some called this a type of nationalization of the GSEs, akin to what the
British government did with Northern Rock bank last year. Others noted that the
rescue package did not include a full and clear expression that the US
government will now stand behind the obligations of the two.
Justin Fox of Time.com's Curious Capitalist blog noted that it seems that the
implicit status of the US government's guarantee of the GSE's obligations has
gone from "not guaranteed by the United States" to "not guaranteed by the
United States, unless they really need to be". Fannie and Freddie shares, as
well as the general stock market, rallied strongly on the news at the market's
open on Monday, but quickly sold off.
Freddie Mac closed down 8% on the day, Fannie Mae 5%, the Dow Jones Industrial
Average closed down 45 points. Perhaps the markets may be now pricing in the
possibility that the Bush administration, in a last, flaming Gotterdammerung of
free-market philosophy, may indeed put ideology over the fates and fortunes of
the entire US financial system to prove that, indeed, no financial institution
is too big to fail.
What wasn't in the rescue package was a reduction in the interest rates the
Federal Reserve uses to manage the short-term money markets, the Federal
Reserve's target Federal Funds rate. That it didn't do, even though it did
lower by 75 basis points that same rate for the rescue of Bear Stearns in
March. The fact that it didn't on this occasion, with the potential insolvency
of Fannie and Freddie posing a far greater systemic risk to the economy than
the potential bankruptcy of a mere investment bank such as Bear, demonstrates
much about the true dire nature of the current circumstances.
After dropping the Federal Funds Target Rate from 5.25% to 2% in eight months,
starting in April the Federal Reserve looked around, and, to paraphrase Captain
Renault (Claude Rains) from 1942's Casablanca, was "shocked, shocked" to
find inflation going on.
The standard remedy applied by central banks to an inflationary problem is a
hike in interest rates, but, even with rising prices, led by surging futures
prices for food and crude oil and its products, moving to the forefront of the
Fed's concern since late April, Bernanke and Co have resisted pulling the
trigger on a rate hike. Instead, they have resorted to attacking inflation with
ever harsher and harsher language, culminating with the statement that followed
the Fed's last meeting on June 25 that seemed to virtually guarantee a rate
hike in the near future (see
Bernanke's words strike false note, Asia Times Online, June 27, 2008.)
Bernanke's portion in the GSE rescue package is currently limited to the
opening of the discount window. That correlates to how he has been dealing with
the twin threats of inflation and financial system instability lately: let the
endangered institution borrow from the Fed what it needs but limit the
provision of excess liquidity to the general economy.
How long can this policy bifurcation continue? The "Lex" columnist of the
Financial Times, which on Saturday described Fannie and Freddie as being like
"like a sweet old couple who have suddenly become unhinged and taken their
neighbors hostage", also said that the crisis means that you can "forget about
higher interest rates, complicating matters for central banks everywhere". This
will be particularly likely if, as what seemed to happen with Fannie and
Freddie's stock price on Monday, the market sees through the continuing lack of
an explicit pledge to cover the GSEs' debts and starts to sell the stocks down
hard once again.
Thus, the core dilemma. The market wants, and has been led to expect, higher US
short-term interest rates, but with the credit crisis continuing to destroy
wealth and value everywhere it goes, can the Fed really risk pulling more
liquidity out of the system with a rate hike at either its upcoming August 5,
or, at the very latest, its September 16 meeting? If it disappoints the markets
again, if it is seen to be going back on its word, does it risk a massive loss
of credibility in the US financial system, with potential huge subsequent
selloffs in the US dollar and US equities?
In Jaws, after it is discovered that the killer shark is still alive,
shark expert Matt Hooper (Richard Dreyfus) tells Amity Police chief Martin
Brody (Roy Scheider) that he has a bigger concern than just closing the beaches
- "You got a bigger problem than that Martin, you still got a hell of a fish
out there."
Likewise, the killer shark of the credit crisis is still out there, chomping
away on the flesh and sinews of the financial markets to its heart's content.
The citizens of Amity finally gathered the cojones to hire shark hunter Quint
(Robert Shaw) to kill the beast, but in today's totally politically
dysfunctional and polarized America, it seems that the operating strategy is to
let the monster continue to feed on the innocents until well satiated.
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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