Page 1 of 4 Debt capitalism self-destructs
By Henry C K Liu
In a period of less than a year, what had been described by US authorities as a
temporary financial problem related to the bursting the housing bubble has
turned into a fully fledged crisis at the very core of free-market capitalism.
A handful of analysts have been warning for years that the wholesale
deregulation of financial markets and the wrong-headed privatization of the
public sector during the past two decades would threaten the viability of
free-market capitalism. Yet ideological neoliberal fixation remain firmly
imbedded in US ruling circles, fertilized by irresistible campaign
profiteers on Wall Street, methodically purging regulatory agencies of all who
tried to maintain a sense of financial reality.
This ideology of "market knows best" has allowed the nation to slip into an
unsustainable joyride on massive debt giddily assumed by all market
participants, ranging from supposedly conservative banks, investment banks and
other non-bank financial institutions, to industrial corporations, government
sponsored enterprises (GSEs) and individuals.
The once-dynamic US economy has turned itself into a system in which it is
difficult to find any institution, company or individual not over their head in
speculative debt. Undercapitalized capitalism, also known as debt capitalism,
has been the engine of growth for the US debt bubble in the last two decades.
This debt capitalism cancer is caused by a failure of central banking.
In the face of a broad systemic collapse of debt capitalism, where capital has
become dangerously inadequate and new capital hazardously and prohibitively
scarce, having been crowded out by massive debt collateralized by overblown
assets of declining value and with a credit crisis that clearly requires
systemic restructuring and comprehensive intensive care, those in the US
responsible for the financial well-being of the nation seem to have been
reacting tactically from crisis to crisis with a script of adamant denial of
obvious facts, symptoms and trends, with no signs of any coherent grand
strategy or plan to save the cancerous system from structural self-destruction.
This band-aid short-term approach to artificially pop up share prices in the
collapsing equity market and to maintain insolvent financial institutions with
technical life-support will lead only to long-term disaster for the whole
Yet this approach is preferred by those in authority, trapped in self deception
about unregulated market capitalism being still fundamentally sound. They try
to calm markets by asserting that the current turmoil is merely a minor
liquidity bottleneck that can be handled by the central bank releasing more
liquidity against the full face value of collaterals of declining worth.
The message is that somehow, if easy money in the form of debt is made
endlessly available, the economy will recover from this credit crunch,
notwithstanding that excessive debt has been the cause of the problem; or bad
loans can be made good by Congress giving the US Treasury authority to buy up
bad loans with unlimited amounts of taxpayer money.
Yet these incremental measures taken so far by the Treasury and the Federal
Reserve make the two government units with direct responsibility on the
nation's long-term financial health look like panicky rogue traders trading for
the national account in desperate hope to score a win in the next quarter by
upping the ante, to contain allegedly isolated crisis hot points. The aggregate
effect adds up to a broad stealth nationalization of the insolvent financial
sector. Their prescription for stabilizing a debt-destabilized market is more
public debt to support corporation socialism.
For years, anyone warning that the government sponsored enterprises (GSEs),
namely Fannie Mae and Freddie Mac, should be held to normal capitalization
requirements was ridiculed as a fear monger by the powerful lobbying machines
these GSEs employed. Capital is considered as superfluous in the new game of
debt capitalism held up by complex circular hedging. As a result, the GSEs have
become the monstrous tail that wags the dog of housing finance.
The current talk about the need to curb speculation in the commodities and
financial markets to stabilize prices is off target, especially for believers
of market capitalism. All market transactions are speculative in nature.
Speculation can stabilize prices as well as to destabilize them, but only in
the short term. Long-term price levels (inflation or deflation), as Milton
Friedman aptly observed, are always monetary phenomena. The current turmoil in
the financial system, the subprime mortgage implosion, the credit crisis from
the seizure in the asset-backed commercial papers market, the
undercapitalization of commercial and investment bank, the rating agency
dysfunction, the insolvency of monocline (bond) insurers, the massive financial
losses by the GSEs and a host of other financial problems percolating under the
media radar, are the outcome, and not the cause, of this market turbulence.
(See Perils of
the debt-propelled economy, Asia Times Online, September 14, 2002.)
Fanny Mae and Freddy Mac, GSEs that have provided mortgage funds for the
housing market since 1938, were created as part of the New Deal to help
low-income families. They were privatized in 1968 on terms that would alter
their social mandate and would inevitably lead them into financial trouble on a
big scale. Finally but suddenly, these GSEs find themselves in danger of
defaulting on their massive debts, upwards of US$5 trillion, in the course of a
Deeply rooted in US political culture is the view that credit is a financial
public utility, much like air and water, and should be equally accessible to
all, not just to the rich. Economic democracy has been the core strength of US
political democracy. Government loan guarantees for students and home mortgages
for low- and moderate-income groups and loans to small business are based on
this principle. Yet from time to time, this principle of economic democracy is
overshadowed by free-market extremism to push the nation's economy into
The US National Housing Act was enacted on June 27, 1934, as one of several
economic recovery measures of the New Deal to get the nation out of the Great
Depression. It provided for the establishment of a Federal Housing
Administration (FHA). Title II of the Act provided for the insurance of
home-mortgage loans made by private lenders, taking the disaggregated risk in
lending to low-income borrowers off private lenders and managing the risk on a
national scale with a government agency to take advantage of the law of large
numbers, a theorem in probability that describes the long-term stability of a
random variable. Title III of the Act provided for the chartering of national
mortgage associations by the FHA administrator. These associations were to be
independent corporations regulated by the administrator, and their chief
purpose was to buy and sell the mortgages insured by the FHA under Title II.
Only one association was ever formed under this authority. On February 10,
1938, this association, the National Mortgage Association of Washington, became
a subsidiary of the Reconstruction Finance Corp, a government corporation. Its
name was changed that same year to Federal National Mortgage Association
(Fannie Mae). By amendments made in 1948, Title III of the US National Housing
Act became a statutory charter for Fannie Mae.
Balloon payment barrier
Before the Great Depression, affording a home was difficult for most people in
the US. At that time, a prospective homeowner had to make a down payment of 40%
and pay the mortgage off in three to five years. Until the last payment,
borrowers paid only interest on the loan. The entire principal was paid in one
lump sum as the final "balloon" payment. Lenders could demand full payment of
the outstanding loan at any time of the lender's choosing, often at time least
advantageous to borrowers. This allowed lenders to use foreclosures as a means
to take over desirable properties.
During the 1920s boom time in real estate, a rudimentary secondary mortgage
market had come into being. The stock-market crash of 1929 ended the
real-estate boom and forced many private guarantee companies into insolvency as
home prices collapsed. As economic conditions worsened, more and more borrowers
defaulted on mortgages because they couldn't come up with the money for the
final balloon payment or to roll over their mortgage because of low market
value of their homes.
To help lift the country out of the Great Depression, Congress created the FHA
through the National Housing Act of 1934. The FHA's insurance program protected
mortgage lenders from the risk of default on long-term, fixed-rate mortgages.
Because this type of mortgage was unpopular with private lenders and investors,
Congress in 1938 created Fannie Mae to refinance FHA-insured mortgages.
As soldiers came home from World War II, Congress passed the Serviceman's
Readjustment Act of 1944, which gave the Department of Veterans Affairs (VA)
authority to guarantee veterans' loans with no down payment or insurance
premium requirements. Many financial institutions considered this arrangement a
more attractive investment than war bonds.
By revision of Title III in 1954, Fannie Mae was converted into a
mixed-ownership corporation, its preferred stock to be held by the government
and its common stock to be privately held. It was at this time that Section 312
was first enacted, giving Title III the short title of Federal National
Mortgage Association Charter Act.
By amendments made in 1968, the Federal National Mortgage Association was
partitioned into two separate entities, one to be known as the Government
National Mortgage Association (Ginnie Mae), the other to retain the name
Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in the
government, and Fannie Mae became privately owned by retiring the
government-held stock. Ginnie Mae has operated as a wholly owned government
association since the 1968 amendments. Fannie Mae, as a private company
operating with private capital on a self-sustaining basis, expanded to buy
mortgages beyond traditional government loan limits, reaching out to a broader
By the early '70s, inflation and interest rates rose drastically. Many
investors drifted away from mortgages. Ginnie Mae eased economic tension by
issuing its first mortgage-backed security (MBS) guarantee in 1970. Investors
found these guaranteed MBSs highly attractive. Also in 1970, under the
Emergency Home Finance Act, Congress chartered the Federal Home Loan Mortgage
Corp (Freddie Mac) to buy conventional mortgages from federally insured
financial institutions. The legislation also authorized Fannie Mae to purchase
conventional mortgages. Freddie Mac introduced its own MBS program in 1971.
Fannie and Freddie charters give these GSEs exemptions from state and local
taxes, allow them relatively meager capital requirements, and provide them with
an ability to borrow money at lowest possible rates to lend at near market
rates. Over the years, this advantage has served not to lower home prices and
mortgage payments to help low-income buyers but to enrich debt securitizers and
Aging credit line
Each agency now has a $2.25 billion credit line with the Treasury, set nearly
40 years ago by Congress at a time when Fannie had only about $15 billion in
outstanding debt. It now has total debt of about $800 billion, while Freddie
has about $740 billion. Today the two companies also hold or guarantee loans
with face value of more than $5 trillion, about half the nation's mortgages.
Market analysts estimate that the market value of this liability may be less
than 50% unless the housing market recovers. In other words, the GSEs face a
$3.5 trillion exposure to default if they cannot raise new funds in the credit
In the early 1980s, the US economy spiraled into deep recession. Interest rates
were high while house prices while falling, remaining beyond the reach of many
low- and moderate-income buyers because income growth stayed stagnant. The US
economy faced a dual problem of income deficiency and money devaluation. In
this poor housing market environment, Ginnie Mae, Fannie Mae and Freddie Mac
all created programs to handle adjustable-rate mortgages. The Ginnie Mae
guaranty is backed by the full faith and credit of the United States. Today,
Ginnie Mae guaranteed securities are one of the most widely held and traded
MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion in MBSs.
Historically, 95% of all FHA and VA mortgages have been securitized through
Ginnie Mae. Ginnie Mae is a guarantor, a surety. Ginnie Mae does not issue,
sell, or buy MBSs, or purchase mortgage loans. Ginnie Mae is not in financial