In These New Times

A new paradigm for a post-imperial world

Jaws close in on Bernanke

Posted by seumasach on July 16, 2008

“No one who has wealth or assets in any form, in any currency, is safe – you might as well consider yourself as being at least knee-deep in the shark infested waters of the financial markets.”

By Julian Delasantellis 

Asia Times

As he was winding down his days of dissoluteness and reprobation, the 4th century Christian philosopher Augustine of Hippo, commonly referred to as St Augustine, begged for just a few more rounds of divinely sanctioned debauchery. “Lord,” he cried out to the heavens, “Give me chastity and continence, but not quite yet.” 

Currently, as a result of the ever-worsening crises in US housing finance, a crisis being illustrated by the absolute devastation of the shares in the US government’s semi-private semi-public secondary market mortgage wholesalers Fannie Mae and Freddie Mac, and in the government seizing control of mortgage lender IndyMac in one of the largest bank failures in American history, Federal Reserve chairman Ben Bernanke must be raising higaze to the heavens for a similar entreaty. 
“Lord, give me credibility as, and the ability to be, an inflation fighter – but not quite yet.” 

The history of the financial markets since the rescue of Bear Stearns last March 15 is similar to that of the fictional Amity Island in between the first Jaws movie, released in 1975, and its sequel, Jaws 2, from 1978. 

At first, after the initial shark had been killed, after Bear Stearns had been saved by aggressive Federal Reserve intervention, everything seemed OK. The markets rallied into mid-May. I would imagine that the souvenir shops selling shark-themed toys and back scratchers on Amity’s beaches did likewise. But, then, the markets rolled over: the Dow Jones Industrial Average, after topping out close to 13,200 on May 19, has since lost more than 2,000 points, or 15%. To borrow from the tagline of Jaws 2, “Just when you thought it was safe to go into the stockmarket … ” 

Of course, the real danger laying in wait to devour the markets continues to be the crisis in US housing values, as it has now become obvious that the entire edifice of the US financial markets over the past few years has been built on a foundation just about as sturdy as a sandcastle on one of Amity’s beaches – the inflated value of US real estate. 

It had been thought that the crisis in subprime mortgages, the root of the financial crises, would leave Fanny and Freddy untouched, since both their respective charters forbid the two enterprises, called government-sponsored entities (GSEs), from investing in them. But it is truly indicative of just how pernicious and metastizing this crisis is that, after devastating all that it has come in contact with for almost a year and a half now, it now strikes deep at the heart of a target previously thought immune. 

No one who has wealth or assets in any form, in any currency, is safe – you might as well consider yourself as being at least knee-deep in the shark infested waters of the financial markets. 

My colleague Chan Akya ably described this burgeoning crisis last week (see And now, for Fannie and Freddie, Asia Times Online, July 12.) He accurately described the possible grim consequences possibly resulting from it, especially a huge expansion of the US federal government’s indebtedness, but one thing that needs to be stressed is that because of these events the fight against inflation will most likely once again be placed on the back burner. 

“Roosevelt is dead!” the relentlessly rotund radio rabble-rouser Rush Limbaugh cries out every afternoon on the American airwaves, referring to Great Depression and World War II-era US president Franklin Delano Roosevelt. At first, this might seem to be something of an obsessive compulsion with the absolutely obvious, as Roosevelt took his last actual physical breath on earth in April, 1945, shortly before the Allied victory in Europe. 

But what is really being expressed by Limbaugh is less a declarative statement than a fervent wish that conservatism’s triumphs and successes might some day, maybe today, be so overwhelming and comprehensive that, at last, the American public will begin to clamor for the dismantling of the government social safety net emplaced in the Roosevelt era and which has for so long tied the American public to the Democratic Party. 

Shortly after his re-election victory in 2004, George W Bush apparently thought so, for he immediately staked his political capital on a laissez-faire free-market restructuring plan for the gem in the Roosevelt crown, old-age Social Security. That, and the unpopularity over the Iraq war, drove the Republicans from control of both branches of Congress in the 2006 mid-term elections. Former Republican Senator Rick Santorum of Pennsylvania, defeated in 2006, now probably wishes that he did not have supporters at a 2005 rally that included elderly Social Security pensioners chanting the phrase “Hey hey! Ho ho! Social Security’s got to go!” 

Like a fungus that dies on exposure to light, the Bush Social Security scheme was dead a few months after it was released. However, it was then impossible for the general media to cover serious issues for much longer; they had to come up for sweet draughts of clean and clear tabloid oxygen. Starlets were getting drunk and Brangelina was getting pregnant; both warranted more attention than what the Bush administration was doing with the rest of the government, particularly concerning the always riveting, ever-popular issue of financial markets regulation. 

Grover Norquist, the anti-government jihadi who once said that he wanted to shrink government to such a size that it could be drowned and killed in a bathtub, and his fellow zealots in the Bush administration, certainly got water under their fingernails in dealing with the GSEs. 

In responding to a series of accounting scandals at the agencies similar to what the rest of the private sector suffered in 2002 and 2003 (see The decline of US equity markets, Asia Times Online, May 10, 2007) Bush and Co pushed the line that these agencies, just like the rest of the government, were poor stewards of, and could not be trusted with, the public purse. 

They may have aimed for a bridge too far with the attempted privatization of Social Security, but in then aiming squarely at Fannie and Freddie, which, by financing the suburbs that the GIs returning from World War ll populated en masse, influenced the shape of postwar American life as much as the automobile, the anti-government zealots were zeroing in on a very critical consolation prize. 

Hoping to hobble the decision making of the two housing agencies, Bush stopped making new appointments to the boards of the GSEs in 2004. He also restricted the amount they could underwrite. There were repeated calls for new regulation of Fannie and Freddie, probably just about the only calls for enhanced regulation that have come out of the US executive branch this millennium. Hearings in the then Republican-controlled Congress were laced with outrage for these two wasteful, bloated government enterprises, whose functions could obviously be carried out in a far superior fashion by the private sector. 

The Internet from that era is littered with weighty think tank tomes by such reliably conservative outlets as American Enterprise Institute and Cato Institute, calling for a new, private-sector, risk-transfer mechanism that was not centered around the GSEs. As in the famous curse where the Greek gods would punish mortals by granting their every wish, the free marketeers would get their wish in the next few years, to their, and the rest of the financial markets, continuing mortification. 

The core of Freddie and Fannie’s operations was to buy up mortgage-backed securities in the open market then either hold them to maturity or sell them back to the market as mortgage-backed securities with the US government’s implied backing. Both dispositions transferred the risk of mortgage default away from the banks to Fannie and Freddie. 

Up until the freeze up in the credit markets and the crash in subprime finance that occurred last summer, a new risk-transfer mechanism stood as competition in the wholesale mortgage markets. Market shills postulated that, since it did not require participation by the government, it was obviously superior. 

Instead of having Fannie and Freddie buy the mortgage securities, the new plan involved these being rolled up into mortgage-backed securities (MBS), then sold to other private investors, whether they be other commercial and investment banks, hedge funds, or even, as the New York Times reported last December, the city treasury of Narvik, Norway. 

After they were sold off once, they were invariably sold off again and again and again, each time, due to the devastatingly alluring miracle of leverage, the original nominal amount of the mortgage being used as collateral for much larger amounts of borrowing and lending. 

But by not retiring the mortgages with the GSEs, whoever did wind up with the bonds were still stuck with the risk that the mortgage holders might someday default on the loans. This eventuality was to be covered with an instrument called a credit default swap (CDS), in essence, an insurance policy the bondholder would purchase from a bank that would pay off in case of a mortgage holder’s default. 

With the stranglehold that the Bush administration, and its threatened veto pen, had on any legislative attempts to modernize and adapt the GSEs to current times, slowly the US mortgage market began to evolve away from the purview of Fannie and Freddie. 

Regulations prevented Fannie and Freddie from buying up, from “underwriting”, most subprime mortgages because these typically did not carry the substantial borrower downpayments and detailed financial documentation that the agencies’ regulations required. This, about one third of all mortgage borrowing as the real estate boom frothed over from 2004-2006, went to the CDSs. So did the wholesale market for mortgage loans above the GSEs’ statutory limits of $417,000; this meant that, by the end of the boom, even modest three-bedroom, one-bath bungalows in the coastal markets of California and the US Northeast were not longer being underwritten by Fannie and Freddie. By early 2007, as the greed crescendo peaked, Fannie and Freddie were underwriting a mere 40% of the US mortgage market, down from over 60% earlier in the decade. 
The rest, of course, is the grim history of the past two years. The subprime market cracked, leading the holders of the CDSs connected with the subprime obligations to start demanding their promised payment from the specialized CDS private insurers, called “monolines”. This essentially drove the monolines to the brink of bankruptcy. The shutdown of the market for credit default swaps is what lies at the heart of what we now call the credit crisis. 
Even though they did not make many subprime mortgage loans, Fannie and Fannie still fell victim to the age’s greed and arrogance. On any cul-de-sac, in any new housing development, the bankruptcy and forced foreclosure sales of the homes with the subprime mortgages are forcing down the real estate values of the rest of the homes, the ones underwritten by Fannie and Freddie, in the neighborhood. 

As the US real estate market staggered and buckled before finally breaking last summer and autumn, some voices were raised advocating fighting the then still-nascent crises with greater participation by Fannie and Freddie, specifically, by allowing the two to buy more, and higher-priced, mortgages. 

This could have nipped the problem in the bud, but back last year, Bush, still the free markets’ ever-trustworthy troubadour, informed one and all that he would veto any legislation of that nature. 

Bush saw the light (probably through feeling the heat that was being placed on his party’s election prospects this year), and included in last winter’s economic stimulus package a geographically limited, temporary increase in the GSE’s statutory loan limits, in certain high priced markets, to just under US$730,000. Still, increased authority by Fannie and Freddie are key elements of the mortgage relief rescue package promoted by Democrats Representative Barney Frank and Senator Chris Dodd and now slogging through the Congress, weighed down by Republican legislative legerdemain. Bush has not said one way or another whether he will sign the bill should it reach his desk; every time he implies he might veto the bill, you can just hear the whoosh of the darts heading towards pictures of the president at John McCain’s campaign headquarters. 

Current reports are indicating that the GSEs are now purchasing about 80% of the new mortgages being made in the US. This is why the two’s current financial difficulties, symbolized by the roughly 90% falls in the stock values of both Fannie and Freddie since last August, are so serious. 

Governments rush in to rescue endangered financial institutions when they are said to be “too big to fail”; if ever that was true, if ever the maxim had any real applicability, surely, with essentially the entire US housing industry now resting on the GSEs’ shoulders, the US government cannot stand by disinterested as they bleed to death. 

On Sunday evening, the US Treasury Department and Federal Reserve came out with a Fannie/Freddie rescue plan. President Bush was nowhere to be seen in this initiative – the Wall Street Journal reported that there were still free-market holdouts in the White House, apparently the last laissez-faire zealots left in the bunker as reality’s punishing howitzers zeroed in, that opposed the deal. 

The initiative called for a temporary increase in what the GSEs could borrow from the Treasury, as well as increased US government equity investments in Fannie and Freddie stock. These will require authorization from Congress. For its part, the Federal Reserve announced that, for the first time, it was opening its emergency assistance facility, or discount window, designed for member banks (which the GSEs are not – they’re not really “banks” at all) to the endangered pair. 

Some called this a type of nationalization of the GSEs, akin to what the British government did with Northern Rock bank last year. Others noted that the rescue package did not include a full and clear expression that the US government will now stand behind the obligations of the two. 

Justin Fox of’s Curious Capitalist blog noted that it seems that the implicit status of the US government’s guarantee of the GSE’s obligations has gone from “not guaranteed by the United States” to “not guaranteed by the United States, unless they really need to be”. Fannie and Freddie shares, as well as the general stock market, rallied strongly on the news at the market’s open on Monday, but quickly sold off. 

Freddie Mac closed down 8% on the day, Fannie Mae 5%, the Dow Jones Industrial Average closed down 45 points. Perhaps the markets may be now pricing in the possibility that the Bush administration, in a last, flaming Gotterdammerung of free-market philosophy, may indeed put ideology over the fates and fortunes of the entire US financial system to prove that, indeed, no financial institution is too big to fail. 

What wasn’t in the rescue package was a reduction in the interest rates the Federal Reserve uses to manage the short-term money markets, the Federal Reserve’s target Federal Funds rate. That it didn’t do, even though it did lower by 75 basis points that same rate for the rescue of Bear Stearns in March. The fact that it didn’t on this occasion, with the potential insolvency of Fannie and Freddie posing a far greater systemic risk to the economy than the potential bankruptcy of a mere investment bank such as Bear, demonstrates much about the true dire nature of the current circumstances. 

After dropping the Federal Funds Target Rate from 5.25% to 2% in eight months, starting in April the Federal Reserve looked around, and, to paraphrase Captain Renault (Claude Rains) from 1942’sCasablanca, was “shocked, shocked” to find inflation going on. 

The standard remedy applied by central banks to an inflationary problem is a hike in interest rates, but, even with rising prices, led by surging futures prices for food and crude oil and its products, moving to the forefront of the Fed’s concern since late April, Bernanke and Co have resisted pulling the trigger on a rate hike. Instead, they have resorted to attacking inflation with ever harsher and harsher language, culminating with the statement that followed the Fed’s last meeting on June 25 that seemed to virtually guarantee a rate hike in the near future (seeBernanke’s words strike false note, Asia Times Online, June 27, 2008.) 

Bernanke’s portion in the GSE rescue package is currently limited to the opening of the discount window. That correlates to how he has been dealing with the twin threats of inflation and financial system instability lately: let the endangered institution borrow from the Fed what it needs but limit the provision of excess liquidity to the general economy. 

How long can this policy bifurcation continue? The “Lex” columnist of the Financial Times, which on Saturday described Fannie and Freddie as being like “like a sweet old couple who have suddenly become unhinged and taken their neighbors hostage”, also said that the crisis means that you can “forget about higher interest rates, complicating matters for central banks everywhere”. This will be particularly likely if, as what seemed to happen with Fannie and Freddie’s stock price on Monday, the market sees through the continuing lack of an explicit pledge to cover the GSEs’ debts and starts to sell the stocks down hard once again. 

Thus, the core dilemma. The market wants, and has been led to expect, higher US short-term interest rates, but with the credit crisis continuing to destroy wealth and value everywhere it goes, can the Fed really risk pulling more liquidity out of the system with a rate hike at either its upcoming August 5, or, at the very latest, its September 16 meeting? If it disappoints the markets again, if it is seen to be going back on its word, does it risk a massive loss of credibility in the US financial system, with potential huge subsequent selloffs in the US dollar and US equities? 

In Jaws, after it is discovered that the killer shark is still alive, shark expert Matt Hooper (Richard Dreyfus) tells Amity Police chief Martin Brody (Roy Scheider) that he has a bigger concern than just closing the beaches – “You got a bigger problem than that Martin, you still got a hell of a fish out there.” 

Likewise, the killer shark of the credit crisis is still out there, chomping away on the flesh and sinews of the financial markets to its heart’s content. The citizens of Amity finally gathered the cojones to hire shark hunter Quint (Robert Shaw) to kill the beast, but in today’s totally politically dysfunctional and polarized America, it seems that the operating strategy is to let the monster continue to feed on the innocents until well satiated. 

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached 

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