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By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Limited

The worst stage of the credit crisis may have arrived.  The pillars of the U.S. mortgage industry, the Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, are collapsing.  They are government sponsored enterprises (GSEs) and are perceived as too big to fail, as their failures would cut off funding for the US housing market.  They own ＄1.5 trillion of mortgage assets and guarantee another ＄3.9 trillion, covering half of the mortgages in the U.S.  The government has to bail them out.

The current crisis is due to excessive borrowing for property purchases.  'Financial innovations' in recent years purported to decrease risks to credit investors, which allowed less capital and more debt for property purchases.  In addition to their traditional business of buying mortgages from banks for securitization, Fannie Mae and Freddie Mac bought new financial products that supported the credit derivative market.  Their support for the new financial products was the key to their viability, both due to their size and their high credit rating as GSEs.  As it turns out, the risk reduction from financial innovations was an illusion.  The perceived reduction in risk was due to the bubble that the belief in risk reduction caused.  As these two institutions collapse, the heart of the credit bubble is exposed.  This may be the worst moment in the ongoing crisis.

The crisis won't end with the collapse and bailout of these two institutions.  More financial institutions like regional banks may fail. For example, IndyMac Bank, a prolific mortgage specialist that helped fuel the housing boom, was seized July 11 by federal regulators, in the third-largest bank failure in U.S. history.  The failure may cost the Federal Deposit Insurance Corp. between US＄ 4 billion and US＄ 8 billion, potentially wiping out more than 10 percent of the FDIC's US＄ 53 billion deposit-insurance fund.  Indeed, the Federal government may have to recapitalize the FDIC soon.  Some estimates put the total loss from the current credit crisis at US＄ 1 trillion.  The recognized losses so far, including the loss estimates for Fannie Mae and Freddie Mac, are half that.

Even the trouble on Wall Street is far from over.  The death of the Bear Stearns doesn't give everyone else the license to live.  They are temporarily being kept alive by the Fed's liquidity support.  Several Wall Street institutions may be comatose already.  Like patients in a vegetative state, their deaths are all but recognized.  In one year's time, Wall Street will have fewer players left standing.

The U.S. Treasury Secretary, Hank Paulson, announced interim stabilization measures and the intention to secure congressional authorization to bail out the two institutions.  The interim measures are to sustain their operations by making the implicit government guarantees on their debts explicit.  Investors can continue to purchase their bonds to sustain their operations-buying mortgages for securitization.  Otherwise, there would be no financing for the U.S. housing market.  One of the interim measures is for the Fed to make its short-term lending facility available to them.  The Fed is already lending directly to investment banks.  By lending directly to these two mortgage behemoths, it shows that the U.S. is printing money to bail out its financial system and, ultimately, monetize the losses from the property price decline.

The bailouts of Fannie Mae and Freddie Mac will weaken the dollar, increase inflation, and boost bond yield.  I believe that the bailout money will ultimately come from the Fed printing money or partly from the Treasury issuing bonds.  As I argued last August, a Fed bailout would boost money supply and inflation via commodity speculation.  The U.S. can monetize the losses from its financial crisis because the dollar is a global currency and monetization causes the dollar to depreciate but not collapse.  As international investors hold ＄16 trillion of U.S. dollar financial assets, monetization is a preferred strategy for the U.S.; foreigners may share one third of the cost through inflation and dollar depreciation.  To stop it, foreign investors should sell U.S. treasuries now to drive up the bond interest rate sky high, which would deter the Fed from printing money.  So far, international investors, mainly central banks, are scared stiff and don't know what to do.  The U.S. is taking advantage of the opportunity to stuff the world with its losses.

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