The next big wave is breaking
By F William Engdahl
The announcement by US Treasury secretary Henry Paulson, together with Federal
Reserve chairman Ben Bernanke, that the US government will bail out the two
largest guarantors of the country's housing mortgage debt - Fannie Mae and
Freddie Mac - far from calming financial markets has confirmed what we have
said repeatedly in this space: the financial tsunami that began in August 2007
in the relatively small "subprime" high-risk mortgage securitization market,
far from being over, is only gathering momentum.
As with the tsunami that devastated Asia in wave after terrifying wave in
December 2004, what we are witnessing now is a low-amplitude, long-wave
phenomenon of trillions of dollars of financial
securities being unwound, defaulted on, and dumped on the market.
The scale of the latest wave to hit, the collapse of confidence in the two
government-sponsored entities, Freddie Mac and Fannie Mae, is a harbinger of
worse to come in what will be the most devastating financial and economic
catastrophe in United States history. The impact will be felt globally.
The Royal Bank of Scotland (RBS), one of the largest financial institutions in
the European Union, has warned its clients that "a very nasty period is soon to
be upon us - be prepared". RBS expects the S&P-500 index of US stocks, one
of the broadest stock indices in Wall Street used by hedge funds, banks and
pension funds, could lose almost 23% by September as, in the bank's phrase,
"all the chickens come home to roost" from the excesses of the US-led
securitization revolution that took hold after the dot.com bubble burst and
then Fed chairman Alan Greenspan lowered US interest rates to levels not
sustained since the 1930's Great Depression.
This will be seen in history as the disastrous Greenspan "Revolution in
Finance" - an experiment in asset-backed securitization, a mad attempt to
bundle risk into loans, "securitize" them in new bonds, insure them via
specialized insurers called "monoline" insurers (which insured only financial
risks in bonds), then rate them via Moody's and Standard & Poor's as AAA,
or highest grade. All that was done so that pension funds and banks around the
world would assume they were high-quality debt.
Fed in panic mode
While he is getting praise in the financial media for his "innovative" and
quick reactions to the unraveling crisis, Fed chairman Bernanke in reality is
in a panic mode. His room to act is increasingly bound by the soaring asset
price inflation in food and oil, which is pushing consumer price inflation to
new highs even by the doctored "core inflation" model of the Fed.
If Bernanke continues to provide unlimited liquidity to prevent a banking
system collapse, he risks destroying the US corporate and Treasury bond market
and with it the dollar. If Bernanke acts to save the heart of the US capital
market - its bond market - by raising interest rates, the Fed's only
anti-inflation weapon, it will only trigger the next even more devastating
round in tsunami shock waves.
The US government passed the law creating Fannie Mae in 1938 during the Great
Depression as part of president Franklin D Roosevelt's New Deal. It was
intended to be a private entity, although "government sponsored", that would
enable Americans to finance buying of homes as part of the country's attempt at
economic recovery. Freddie Mac was formed by Congress in 1970, to help revive
the home-loan market. Congress started the companies to promote home buying and
their charters give the Treasury the authority to extend a US$2.25 billion
credit line.
The problem with the privately owned government-sponsored entities, or GSEs, as
they are technically known, is that Congress tried to fudge on whether they
were subject to government guarantee in the event of a financial crisis such as
the present one. Before now, that appeared a manageable problem. No more.
The United States economy is in the early phase of its worst housing-price
collapse since the 1930s. No end is in sight. Fannie Mae and Freddie Mac, as
private stock companies, have gone to excesses in leveraging their risk, much
as many private banks did. The financial market bought the bonds of Fannie Mae
and Freddie Mac because they bet that the two were "too big to fail," that is,
in a crisis the government - more accurately the US taxpayer - would be forced
to step in and bail them out.
The two companies either own or guarantee about half of the $12 trillion in
outstanding US home mortgage loans, or $6 trillion - which is also about half
the combined gross domestic product (GDP) of the entire 27 member states of the
European Union in 2006, or almost three times Germany's GDP that year.
In addition to their home mortgage loans, Fannie Mae has $831 billion in
outstanding corporate bonds and Freddie Mac $644 billion.
Freddie Mac owes $5.2 billion more than its assets today are worth, meaning
under current US "fair value" accounting rules, it is insolvent. Fair value of
Fannie Mae assets has dropped 66% to $12 billion and may go negative next
quarter. As home prices continue to fall across America, and corporate
bankruptcies spread, the size of the negative values of the two will explode.
On July 14, Treasury secretary Paulson, former chairman of Wall Street
investment bank Goldman Sachs, stood on the steps of the Treasury building in
Washington, in a clear attempt to add gravitas to the occasion, and announced
that the George W Bush administration would submit a bill proposal to Congress
to make taxpayer guarantee of Freddie Mac and Fannie Mae explicit. In effect,
in the present crisis it will mean nationalization of the $6 trillion agencies.
The bailout statement by Paulson was accompanied by an announcement by Bernanke
that the Fed stood ready to pump unlimited liquidity into the two companies.
The Federal Reserve is rapidly becoming the world's largest financial garbage
dump, as for months it has agreed to accept banks' asset-backed securities,
including sub-prime real estate bonds, as collateral in return for US Treasury
bond purchases. Now it agrees to add to that potentially $6 trillion in GSE
real estate debt.
Yet the disaster in the two private companies was obvious as far back as 2003
when grave accounting abuses were made public. In 2003, William Poole, then
president of the St Louis Federal Reserve, publicly called for the government
to cut its implied guarantee of Freddie Mac and Fannie Mae, claiming then that
the two lacked capital to weather a severe financial crisis. Poole, whose
warnings were dismissed by then Fed chairman Greenspan, called repeatedly in
2006 and again in 2007 for Congress to repeal their charters and avoid the
predictable taxpayer cost of a huge bailout.
Meanwhile some investors are viewing the Paulson bailout not as a bid to rescue
the US economy but a lifeline for his former Wall Street cronies as the
country's big banks teeter towards a financial implosion. What until recently
had been the largest bank in terms of loans outstanding, Citigroup in New York,
has been forced to raise billions in capital from sovereign wealth funds in
Saudi Arabia and elsewhere to remain in business.
In a statement in May, Citigroup's new chairman, Vikram Pandit, announced plans
to reduce the bank's $2.2 billion balance sheet of liabilities. However, he
never mentioned an added $1.1 trillion in Citigroup "off balance sheet"
liabilities, which include some of the highest risk deals in the US real estate
and securitization era it so strongly backed.
The Financial Accounting Standards Board in Connecticut, the official body
defining bank accounting rules is demanding tighter disclosure standards.
Analysts fear Citigroup could face devastating new losses as a result, with the
value of liabilities exceeding the bank’s $90 billion market value. In December
2006, prior to the onset of this financial crisis, Citigroup had a market value
of more than $270 billion.
F William Engdahl is the author of A Century of War:
Anglo-American Oil Politics and the New World Order, Pluto Press Ltd. Further
articles can be found at his website, www.engdahl.oilgeopolitics.net.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
