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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.
As argued above, the financial
crisis is causing global stagflation. The credit crisis bursts the
property bubble, which depresses demand globally. At the same time,
the Fed prints money to bail out the financial system. When the money
flows into the financial system, speculators use it to buy commodities
like oil. Hence, the growth of money supply immediately turns into
inflation for the whole world. The resulting negative interest rates
don't help the economic growth, as it redistributes income to oil
exporting economies that are already spending as much as they can.
Their trade surpluses are recycled into the global financial system to
cause more inflation. This vicious cycle will end when the Fed raises
interest rate to 6 percent and keep it there.
I do expect the Fed to start
raising interest rate after the November presidential election.
Fearing the economic impact, it will do so slowly first, hoping that
small rate hikes could scare away oil speculators. By the second half
of 2009, it will realize that the scare tactic doesn't work and begin
raising interest rate quickly. By the end of 2009, the Fed funds rate
could be close to 5 percent. That will cool oil price. However, as
the economy tankers, the Fed would cut interest rate again in 2010,
which would bring back the speculators. This game of chicken between
the Fed and speculators will continue for many years, causing waves of
inflation like in the 1970s. Eventually, the U.S. government would
appoint a new Paul Volker-like Fed Chairman. The new chairman will
raise interest rate to 10 percent, crushing inflation and speculators
for good. History repeats itself!
Back to the current crisis,
Fannie Mae and Freddie Mac are like state-owned banks in China. They
depend on the perceived government backing to function. Fannie Mae was
created as a state-owned and operated enterprise in 1938 to combat the
Great Depression. It basically supported numerous local Savings and
Loans (S&L) that lent to small town residents for property
purchases. If you have watched the Christmas Movie 'It's a Wonderful
Life' starring Jimmy Stewart, you would know what a local S&L was
and how vulnerable it was to an economic downturn. Fannie Mae bought
mortgages from them to provide them with liquidity, providing funds for
their expansion and keeping them afloat during bank runs. In 1968, it
was corporatized with shares listed in the stock exchange, similar to
what Chinese state banks have done recently. With the development of
mortgage securitization, its role expanded and became more
complicated. It bought mortgages from variety of intermediaries like
banks, finance companies, or investment banks and securitized them in
the capital market. By leveraging the capital market, it became
dominant in the mortgage market. To limit its monopoly power, the U.S.
government chartered Freddie Mac in 1970 to compete against it.
These two institutions have
played an enormous and positive role in spreading homeownership -- the
quintessential American Dream -- since their establishment.
Homeownership is the foundation of a stable market economy. A home
provides the most important consumption and doubles as the most
important asset. Spreading homeownership improves social stability.
Hence, it makes sense for government to lend its credit to make
mortgage cost as low as possible. To control risk, Fannie Mae and
Freddie Mac require the mortgages that they purchase to meet strict
standards in down payment as a share of purchase cost and household
income to debt service ratio. Until the current crisis, they were
always profitable.
There are three reasons that
they have failed. First, the risk control measures that they have are
not sufficient if property price is excessively inflated during a
bubble. The U.S. home value peaked in this cycle at 170 percent of GDP
in value. Compared to the historical average of about 100 percent, the
downside was much greater than the cushion of 20-30 percent of down
payment. As a mortgage contract is a limited liability contract under
the U.S. law, the mean reversion that is occurring now will lead to
defaults by those who experience negative equity. The Case-Schiller
home-price index dropped 15.3 percent in April from one year ago. The
chances are that it could drop by as much in future for the mean
reversion to complete. At the end of March, the two claimed to have
US＄ 81 billion of capital or 1.5 percent of their assets. Obviously,
when property price may decline 30 percent on average, it is easy to
see that they will lose more money than their capital.
Second, as GSE's, they are
called upon to do public services. After the subprime crisis began in
August 2007, politicians called them to stabilize the market. Without
other buyers, they became buyers of the last resort in the mortgage
market. In the first quarter, they bought or guaranteed 81 percent of
all mortgage securities in the first quarter. At a time like this, the
mortgage securities on offer are probably dubious in value, as
financial institutions try to unload the worst assets in their
inventories. While it is too early to assess how much their financial
losses stem from their public service, it is a significant factor in
pushing them under.
Third, as GSEs, they cannot
operate effectively in a complex financial world. Like China's
state-owned enterprises, their employees are similar to civil
servants. The employees on Wall Street who manufacture and sell
complex financial products are highly paid. Their employees are
probably not well equipped to understand the products that Wall Street
offers to them. Hence, Wall Street is probably incentivized to take
advantage of their ignorance. Some of the short sellers of their
stocks told me that they didn’t know what they bought. I am not in a
position to assess this view. But, considering how Wall Street takes
advantage of anyone it can, Fannie Mae and Freddie Mac were probably
the biggest suckers in the credit bubble that Wall Street
manufactured. Of course, as government enterprises, the government is
on the hook for their losses. As the Fed monetizes its losses, all the
dollar holders in the world become suckers.
Many pundits attack Fannie Mae
and Freddie Mac on ideological grounds, calling them socialist
creatures. I don't think that these two institutions are fundamentally
flawed and should exist. Spreading homeownership is the best support
for a stable market economy. A home is both the most important thing
to consume and the most important asset. Making financing available
and at lowest possible cost generates significant externalities that
justify government intervention. When most households own their homes,
a neighborhood functions better as everyone is mindful of their home
value. The synergy effect makes homeownership justifiable for
government intervention.
The U.S. system for supporting
the housing market worked reasonably until the current cycle. The risk
control measures worked well during the previous cycles. The two
institutions have benefited mortgage borrowers by lowering their
interest rate. They basically grant the government credit ratings to
mortgage borrowers. As long as the risk control measures work, it's a
virtuous cycle for both mortgage borrowers and the government. Among
the three reasons that I cited above for their failures, the last one
is key. By buying complex financial products from Wall Street, they
provided the ammunition for the bubble. Government enterprises simply
don’t have the capability to understand complex financial products.
I'm worried that China's state owned financial institutions are too
eager to mix with Wall Street and may be making the same mistake.
This financial crisis is
characterized by rolling explosions in the financial system. There are
no nuclear explosions that expose the problems and mark the bottom. If
Fannie Mae and Freddie Mac were allowed to go bankrupt, it would be the
nuclear explosion to bring the market to the bottom. Of course, the
U.S. government is bailing them out. The crisis will drag on. In
contrast, during the Asian Financial Crisis in 1998, Asian countries
devalued their currencies by half and their stock markets dropped by
over half. Their asset markets shrank quickly by three quarters in
U.S. dollar terms. Their banks went bankrupt quickly. Over a
relatively short period of time, markets were confident that the crisis
bottomed.
The difference is that the
U.S. borrows money in its own currency. When foreigners want their
money back, the Fed can print more money to pay them. For a normal
country, in anticipation of currency oversupply, the exchange rate
would collapse, triggering hyper inflation. Russia experienced this
when it tried to print money to pay off debts ten years ago. But, the
dollar is a global currency. The world economy has fundamental demand
for dollars. Hence, we cannot run out of dollars completely. Printing
money can be an effective strategy for the U.S. to pay for the losses
from the crisis.
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