F. William Engdahl
The announcement by US Treasury Secretary Henry Paulson together with Federal Reserve chief Ben Bernanke, that the US Government will bail out the two largest guarantors of 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 which began in August 2007 in the relatively small “sub-prime” high risk US mortgage securitization market, far from being over, is only gathering momentum. As with the Tsunami which devastated Asia in wave after terrifying wave in December 2004, the financial Tsunami we are witnessing is a low-amplitude, long-wave phenomenon of trillions of dollars of financial securities being unwound, defaulted upon, and dumped into the market.
But the scale of the latest wave to hit, the collapse of confidence in the two Government Sponsored Entities, or GSEs as they are known, 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. Its impact will be felt globally.
The Royal Bank of Scotland, one of the largest financial institutions in the EU has warned its clients “A very nasty period is soon to be upon us—be prepared.” They expect 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. “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 Greenspan lowered US interest rates to levels not sustained since the 1930s Great Depression.
This all will be seen in history as the disastrous Alan Greenspan “Revolution in Finance,”—the experiment in Asset Backed Securitization—a mad attempt to bundle risk in loans, “securitize” them in new bonds, insure them via specialized insurers called “monoline” insurers (backed only through US Treasury bonds), and rate them thereby via Moody’s and S&P as AAA—highest grade. All that was done so that pension funds and banks around the world would assume they were high-quality debt—paying even higher interest than safe US government bonds.
While he is getting praise in the financial media for his “innovative” and quick reactions to the unraveling crisis, the Fed chairman is, in reality, in panic mode with little at hand—short of hyper-inflationary tools ,to deal with the crisis. Yet, his room to act is increasingly bound by the soaring asset price inflation of 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 in order to “prevent” a banking system collapse, he risks destroying the US corporate and treasury bond markets and with it—the dollar.
If Bernanke acts to save the heart of the US capital market—its bond market, by raising interest rates—its only anti-inflation weapon, it will only trigger the next even more devastating round of Tsunami shock waves.
Real Impact of the Bailout
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 “government sponsored” private entity that would enable Americans to finance homes, as part of an economic recovery attempt. 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 $2.25 billion credit line.
The problem with the privately-owned Government Sponsored Entities, is that Congress tried to fudge on whether they would be guaranteed by the US Government in the event of a financial crisis as the present. Before now, it always appeared a manageable problem.
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 excessively leveraged their risk, as most 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,” and that in a crisis the government—that is the US taxpayer—would be forced to step in and bail them out.
Fannie Mae and Freddie Mac either own or guarantee about $6 trillion in US home mortgage loans, or about half of the $12 trillion in such loans outstanding. To put that number into perspective, in 2006 the entire 27 member-states of the European Union had an annual GDP of slightly more than $12 trillion. So this bailout would account for half the GDP of the combined European Union, and almost three times the GDP of the Federal Republic of Germany.
In addition to their home mortgage loans, Fannie Mae holds another $831 in outstanding corporate bonds and Freddie Mac has $644 billion in corporate bonds.
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 as well go negative next quarter. As the 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, symbolically the anniversary of Bastille Day, US Treasury Secretary Paulson, former chairman of the powerful Wall Street investment bank Goldman Sachs, stood on the steps of the US Treasury building in Washington—a clear attempt to add psychological gravitas, and announced that the Bush Administration would submit a bill proposal to Congress to make taxpayer guarantee of Freddie Mac and Fannie Mae explicit. In effect, that will mean the nationalization of the $6 trillion agencies. Paulson’s bailout was accompanied by a statement 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 has agreed to potentially add $6 trillion in GSE real estate debt to that.
However, the looming disaster of the two “private” companies was obvious as far back as 2003 when grave accounting abuses in the two companies were made public. That same year, the St. Louis Federal Reserve then-president William Poole publicly called for the US Government to cut its implied guarantee of Freddie Mac and Fannie Mae, claiming that the two lacked capital to weather a severe financial crisis. Throughout 2006 and 2007, in order to avoid the predictable taxpayer cost of a huge bailout, Poole repeatedly warned Federal Reserve then-Chairman Greenspan and Congress to repeal the charters of Freddie and Fannie.
Financial investors are now warning us that the Paulson bailout is not a bailout of the US economy but a direct bailout of his Wall Street financial cronies. The question is, will we listen this time?