Page 4 of 4 Debt capitalism self-destructs
By Henry C K Liu
Treasury Secretary Henry Paulson said on Friday, July 6 this year that the
government would support the GSEs "in their current form as they carry out
their important mission". On Sunday, the Treasury issued a statement indicating
that
its main focus was still on supporting Fannie and Freddie in their
current form. Fannie Mae and Freddie Mac play a central role in our housing
finance system and must continue to do so in their current form as
shareholder-owned companies. Their support for the housing market is
particularly important as we work through the current housing correction. GSE
debt is held by financial institutions around the world. Its continued strength
is important to maintaining confidence and stability in our financial system
and our financial markets. Therefore we must take steps to address the current
situation as we move to a stronger regulatory structure.
Regulatory
reform while necessary cannot be backdated. There are $5 trillion of
outstanding debt instruments written under
problematic regulatory oversight that need to be dealt with. Expressions of
support for the "current form" that has proved wanting by a wide margin, a new
line of credit to support bad loans and a proposed unlimited injection of
capital by government that would surely face congressional opposition is a
prescription to muddle through a major structural rupture.
Government support
The ability of the GSEs to raise new capital and credit from private sources is
totally dependent on government support. Thus the plan to support these GSEs in
distress will be much more costly if it must be done through private profit
incentives. The outcome is likely to be a new contraction in the supply, and
increase in the cost, of mortgage finance - further lessening the chances of an
early recovery in the housing market and the wider economy. Private profit
incentive overwhelming public interest got the GSEs in trouble. How can more
private profit incentives be expected to get them out of trouble?
The Fed has announced that it will allow Fannie Mae and Freddy Mac to borrow
from its discount widow, normal open only to commercial banks and since March
2008 open also to investment banks as part of the bail out of Bear Stearns.
Under a three-part proposal by the Treasury, the Fed will also be given a
consultative role in setting capital requirements and other regulatory
standards for Fannie and Freddie, as part of an evolution to be the top
regulator and overseer of the nation's financial system.
Former Fed chairman Paul Volcker expressed concern that by expanding its role
of lender of last resort to institutions beside commercial banks that
previously were not allowed to hold positions in equities, the Fed may have
opened itself up to moral hazard dangers if large institutions believe their
adventurous behavior will be bailed out by the Fed.
With the Fed, whose perspective tends to align with those of its member banks,
taking over many of the regulatory powers of the Security Exchange Commission,
whose mandate was originally to protect the interest of small investors, the
public interest may face further diminished protection.
Yet the financial market has irreversibly changed with the emergence of
structured finance in which loan securitization has taken loans that once had
to stay in the balance sheets of issuing banks but are now securitized and sold
by brokers to institutional investors worldwide. Default of a major broker
default, such as Fannie and Freddie, will be as damaging as failure of a major
money-center bank and cause catastrophic collapse of the credit market.
In 1968, then president Lyndon Johnson, as part of his Great Society program,
turned Fannie into a shareholder-owned company as part of a national housing
policy to make finance capitalism finance the nationalization of housing. It
was the beginning of corporate market socialism in the name of populist
economic democracy. The public could only benefit if corporate and financial
institutional interests could profit first. And the public must pay if market
capitalism fails systemically, absolving the losses of wayward corporations and
financial institutions.
In 1970, the savings and loan industry, envying the huge profit made by
commercial and investment banks from Fannie Mae, called for and received
congressional approval for a GSE of their own and Congress created Freddie Mac.
Like the Urban Renewal program of the 1950s, the GSEs served a coalition of
interest that included liberals who wanted to help low-income households, real
state developers that wanted guaranteed demand, home builders that wanted a
guaranteed market, local politicians who wanted tax revenue from redevelopment,
banks that wanted lucrative risk-free loan proceeds and congressmen who wanted
campaign contributions from mortgage lenders.
Too good to be true
Low-income voters were first dazzled by the new homes they were able to acquire
with no money down and with monthly payments financed with home equity loans as
house prices rose. They acted like Pinocchio in a Pleasure Island - that would
soon turn them into jackasses to be sold to work in salt mines. The financial
institutions were comforting their pangs of conscience over taking loans off
their balance sheets as soon as they made them by excusing themselves with the
idea that they were making low-cost mortgage available to millions of
homebuyers. Neoliberal economists were celebrating the US miracle of mass
capitalism that does not need capital.
The program of passing unsustainable loans to faceless investors benefited also
land speculators, home builders, real estate agents, investment bankers,
structured financiers and household furnishers. Since the main thrust of the
GSE program was to help low- and moderate-income homebuyers, opposition was
considered undemocratic.
Yet everyone knows that the GSEs face an interest-rate risk in their long-term
mortgages if interest rates should rise over the loan period. To protect itself
from interest rate risks, the GSEs use derivatives to hedge against
interest-rate risk.
The OFHEO was created by the House Banking Committee chaired by Texas populist
Henry Gonzalez in 1992 with minimal power to regulate the two giant GSEs on the
ground that GSEs were institutions intended to support the national policy of a
nation of homeowners by making housing loans affordable and should be exempt
from regulation regulating commercial institutions.
The problem of this good policy intention was that during the era of neoliberal
ascendancy, the light regulatory environment was used to negate a more
fundamental economic law: the need to increase worker income to match mortgage
payments, subsidized or not.
The GSEs have been financially successful because they combine private sector
appetite for profit with access to government-backed credit at below market
rates. It was a way to nationalize housing through the free market capitalism.
The problem was that financial manipulation cannot replace the need for
adequate income growth. The mismatch of income with asset price is the
definition of a financial bubble. People were buying homes with cheap credit at
prices that their income could not afford. The more home prices rose due to
cheap credit, the more homeowners fell into the debt trap.
Yet in all the current talk about finding ways to deal with the crisis, not one
single voice is heard from official circles about the need to increase worker
income. Instead, false hopes on one-time stimulant tax rebates are hailed as
the magic bullet.
Suddenly this summer, Fannie and Freddie's relatively anemic capital supply is
a serious concern for the market. In one week in July, Fannie's stock plummeted
to $10.25, down 74% in 2008. Freddie's shares also dived, closing at $7.75, a
loss of 77% this year.
Even as investors stampede out of these battered stocks, the sycophants of free
market capitalism in Washington, led by Treasury Secretary Paulson and Federal
Reserve chairman Ben Bernanke, rushed to reassure the market, pointing out that
the mortgage giants' regulators had confirmed that the companies were
"adequately capitalized", trying to give the impression that regulators had the
problem firmly in hand and that no new capital was needed by the GSEs.
But these two leaders had lost much credibility since in August 2007 when they
voiced a similar mantra that problems in the mortgage market were "contained"
to subprime loans and would not spread beyond. SEC chairman Christopher Cox
tried to calm investors by telling them that Bear Stearns passed financial
muster only days before it required a Fed-engineered bail out by JP Morgan
Chase with Fed loans.
More than capital adequacy is at risk. The credibility of the team with
responsibility for the nation's monetary system and its financial market is
heading for a meltdown. Unfortunately, credibility is much easier to lose than
to regain. (See
America's Untested Management Team Asia Times Online, June 17, 2006.)
Recurring anxiety
Anxiety about Fannie and Freddie's liabilities of more than $5 trillion getting
too big for the funding authority of the Federal Reserve of a measly $2.5
billion credit line has been a recurring concern in many quarters in recent
years. Even after both GSEs were found to be infested with accounting
irregularities (Freddie Mac in 2003 and Fannie Mae in 2004), Congress failed to
act, except to make the regulator require the GSEs to hold 30% more capital
than the minimum previously required, in effect capping their ability to
purchase mortgages when the housing bubble was approach its peak.
Still, Fannie and Freddie were allowed to pose as high-growth companies whose
shares were safe enough for widows and orphans. GSE market share fell to 45% at
the peak of the housing bubble. After the bubble burst, it rose to 68% in the
first quarter of 2008.
After empty official assurances failed to convince the market because it was
plain for all to see that the two GSEs' direct and guaranteed liabilities were
almost 65 times their regulatory capital at the end of the first quarter of
2008, the near-term priority was to restore the rapidly fading confidence of
buyers of Fannie's and Freddie's debt, many of whom are foreigners. By
increasing the GSEs' credit line and pushing for authority to inject fresh
equity if necessary, the Treasury's proposed plan appears to be aimed at
allaying fears of widespread counterparty default and market failure. Freddie
seemed to have no serious problem offloading $3 billion of new paper on Monday,
July 14, although arm-twisting was rumored to have been needed to persuade
banks to buy it.
The bigger problem for Washington is that merely stabilizing Fannie and Freddie
is not enough. With US banks seriously distressed by the credit crisis, the
GSEs, which hold or guarantee 22% of the $24.3 trillion outstanding debts
borrowed by US households and the non-financial sector, are a major source of
credit. Yet the market is clearly uncomfortable with the inability of the GSEs
to maintain its over-bloated balance sheet. The options are either to shrink
the balance sheet drastically, thus exacerbating the credit crisis, or to seek
a massive injection of new capital, both requiring government action at an
unprecedented scale.
Despite these ad hoc measures, which may or may not receive congressional
approval, the whole world knows that credit capacity is shrinking drastically
in the market. There are rumors that the US is pressing foreign central banks
to acquire more GSE debt, but the market is inundated with fear of new crises
before the housing market recovers. And the housing market is lying in a coma
in intensive care with an oxygen tank of new credit running near empty.
As the housing market collapses, both GSE companies are reporting steep losses.
But the subprime mortgage meltdown has also made the GSEs more important than
ever in holding up the housing finance sector. Since the credit markets seized
up, Fannie and Freddie have regained their central role in mortgage finance
after losing significant market share to investment banks during the housing
boom. They have issued the vast majority of mortgage securities sold in the
last six months because investors have lost confidence in deals put together by
big investment banks.
In February 2008, prodded by the Treasury, federal regulators announced they
were easing some restrictions on lending by Fannie and Freddie. Then on March
19 the federal government announced that it was easing those restrictions in an
effort to calm the turmoil afflicting the mortgage markets. Officials said the
change could allow the two GSEs to invest $200 billion more in mortgages.
Alarmed by the sharply eroding market confidence in the nation's two GSEs, the
largest mortgage finance companies, the Bush administration announced plans on
Sunday, July 13 to ask Congress to approve a sweeping rescue package that would
give officials the power to inject unlimited funds into the beleaguered
companies through investments and loans.
In a separate announcement, the Federal Reserve said that at the request of the
Treasury it would make one of its temporary short-term lending programs at the
discount window available to the two GSEs, "to promote the availability of home
mortgage credit during a period of stress in financial markets." The program
for the GSEs would end when Congress approves the Treasury's proposed plan.
Treasury Secretary Paulson announced dramatically Sunday on the steps of the
Treasury building: "The president has asked me to work with Congress to act on
this plan immediately. Fannie Mae and Freddie Mac play a central role in our
housing finance system and must continue to do so in their current form as
shareholder-owned companies. Their support for the housing market is
particularly important as we work through the current housing correction."
Paulson paradox
While officials in successive administrations, both Republican and Democrat,
have for many years repeatedly denied that the trillions of dollars of debt
Fannie and Freddie issued is guaranteed by the government, the Paulson package,
if adopted, would bring the Treasury closer than ever to exposing taxpayers to
potentially huge new liabilities. The two GSEs are expected to face significant
new losses this year as the wave of housing foreclosures continues and rises.
Paulson seemed to suggest that there is no choice but for the government to
intervene. The proposed plan, requiring the Treasury to be giving authority by
Congress to command unlimited funds to stabilize the GSEs, is predicated on the
hope that the very availability of unlimited funds would make it unnecessary to
use them. The investment and lending elements of the proposed plan are to last
two years.
Over the weekend, Treasury officials sought assurances from Wall Street firms
that the $3 billion auction on Monday by Freddie Mac of short-term debt would
go off without a hitch. While $3 billion is a relatively small sum for an
institution of Freddie's size, officials said they did not want to risk even a
small misstep that could set off a new round of problems. Despite repeated
assurances by top officials that the companies had adequate cash to weather the
current financial storm, Fannie and Freddie had suffered a withering blow of
confidence the week before. As a result, Freddie was faced with an uncertain
debt offering on Monday. Should Fannie and Freddie fail, $5.3 trillion in
mortgage debt would go unpaid. As it happened, the offering went smoothly but
everyone knew it was not a normal market.
Freddie Mac continued to try to raise capital from private investors even after
a government rescue plan it and its sister company Fannie Mae was announced the
weekend before, indicating concern that the government plan may be delayed in
Congress. On Friday, July 18, Freddie Mac cleared one of the last obstacles to
raising new capital through a planned $5.5 billion stock offering when it
received approval to register with US securities regulators. However, Freddie
Mac's ability to attract much-needed capital from new and existing shareholders
has been potentially lessened by the possibility of a future government stake
that might place restrictions on the business. There is also little clarity
with regard to where in the capital structure the government might invest, and
how dilutive such a move would be to existing shareholders.
The government's rescue plan, which would allow the Treasury unlimited powers
until the end of 2009 to increase its credit line to Fannie Mae and Freddie Mac
and invest in their equity, met some strong vocal resistance in Congressional
hearings during the week before July 18.
While many expect Congress to have no option except to approve the Paulson
plan, a few skeptics were voicing their opposition in public hearings. Senator
Jim Bunning, a Republican from Kentucky, described Paulson as "asking for a
blank check ... for this unprecedented intervention in our free markets." He
also vowed to try his best to stop a proposal that would give the Federal
Reserve sweeping new powers aimed at protecting the nation's shaky financial
system. Bunning said the Federal Reserve "can't be trusted with the power it
already has". He says the Fed's policies in recent years have contributed to
economic woes, including surging inflation, a declining dollar and the housing
bust.
"When I picked up my newspaper yesterday, I thought I woke up in France. But
no, it turns out socialism is alive and well in America. The Treasury Secretary
is asking for a blank check to buy as much Fannie and Freddie debt or equity as
he wants. The Fed's purchase of Bear Stearns' assets was amateur socialism
compared to this," thundered the Republican Senator against his own party's
Treasury secretary. In US political discourse, socialism is a dirty word,
albeit what Paulson proposes is not anywhere near what socialism is commonly
understood to be in the rest of the world, but a scheme to use public funds to
save debt capitalism by frustrating the right to fail in market capitalism.
Predatory lending
Ron Paul, Republican congressman from Texas, told Bernanke that the Federal
Reserve is a "predatory lender". But he did not mention that by law, predatory
lenders forfeit any right of collection.
Lender liability is embodied in common and statutory law covering a broad
spectrum of claims surrounding predatory lending. It is a key concept in
environmental-cleanup litigation. If a lender knowingly lends to a borrower who
is obviously unable to make reasonable beneficial gain from the use of the
funds, or causes the borrower to assume responsibilities that are obviously
beyond the borrower's capacity, the lender not only risks losing the loan
without recourse but is also liable for the financial damage to the borrower
caused by such loans. For example, if a bank lends to a trust client who is a
minor, or someone who had no business experience, to start a risky business
that resulted in the loss not only of the loan but of the client trust account,
the bank may well be required by the court to make whole the client.
In the United States, although predatory lending is not defined by federal law,
and various states define abusive lending differently, it usually involves
practices that strip equity away from a homeowner, or equity from a company, or
condemn the debtor into perpetual indenture. Predatory or abusive lending
practices can include making a loan to a borrower without regard to the
borrower's ability to repay, repeatedly refinancing a loan within a short
period of time and charging high points and fees with each refinance, charging
excessive rates and fees to a borrower who qualifies for lower rates and/or
fees offered by the lender, or imposing new unjustifiably harsh terms for
rolling over existing debt. Predation breaks the links between an economy's
aggregate resource endowment and aggregate consumption and between the
interpersonal distribution of endowments and the interpersonal distribution of
consumption.
The choice by some to be predators decreases aggregate consumption, both
because the predators' resources are wasted and because producers sacrifice
production by allocating resources to guarding against predators. Much of
welfare economics is based on the concept of pareto optimum, which
asserts that resources are optimally distributed when an individual cannot move
into a better position without putting someone else into a worse position. In
an unjust global society, the pareto optimum will perpetuate injustice.
Now, there is a close parallel in most Third World debts and International
Monetary Fund (IMF) rescue packages to the above predation examples, where
sophisticated international bankers knowingly lend to dubious schemes in
developing economies merely to get their fees and high interest, knowing that
"countries don't go bankrupt", as Walter Wriston, former chairman of Citibank,
once famously proclaimed.
The argument for Third World debt forgiveness contains large measures of lender
liability and predatory lending. Debt securitization allows predatory bankers
to pass the risk to global credit markets, socializing the potential damage
after skimming off the privatized profits. The housing bubble has been created
largely by predatory lending without any lender liability. The argument for
forgiving Third World debt is applicable to low- and moderate-income home
mortgage borrowers in the US as well. Let's hear some proactive commitments
from the presumptive candidates of both political parties instead of empty
populist campaign rhetoric.
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.
(Copyright 2008 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
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
