America’s Mortgage Crisis: Bailout or “Nationalization” of the Mortgage Giants?
Posted by seumasach on September 6, 2008
Ellen Brown
5th September, 2008
Fannie Mae and Freddie Mac own or guarantee nearly half the $12 trillion U.S. mortgage market. Not long ago, they were the darlings of Wall Street, ranking next to U.S. bonds as among the safest and most conservative investments in the world. They are called “government-sponsored enterprises” (GSEs), although they are entirely privately owned and specifically disclaim government backing on their prospectuses. The market has taken these disclaimers with a wink and a nod and has assumed that the GSEs are “too big to fail,” forcing the government to save them from their reckless investment schemes. Fannie and Freddie’s preferred shares have been considered so safe that banking regulators let banks count them in the capital required as a cushion against loan losses. This is now proving to be a serious problem, because both the common and preferred shares of the distressed duo are suddenly plunging. Between May 15 and August 25, Fannie’s common shares lost 77% of their value, while its preferred shares lost 58.8% in that short time. Freddie Mac’s preferred shares plunged even more, down 65.5%.1 That could be a disaster for many banks, which are loaded to the gills with these preferred shares. Banks already reeling from losses on mortgages and mortgage-backed securities are now being hit at the core, shrinking their capital base. Loss of bank capital works as leverage in reverse: at a capital requirement of 10%, $1 lost in capital wipes out $10 in loans. Ironically, the recent plunge in Fannie and Freddie shares has been blamed on the bailout plan that was supposed to save them. In July, Treasury Secretary Hank Paulson sought and was granted the authority to extend an unlimited credit line to the GSEs, which now have liabilities totaling about $5 trillion; and to capitalize them by buying their stock, effectively nationalizing them. At a July 15 hearing in Washington, Paulson assured a group of Senators that Congress probably would not have to go through with the plan. “If you have a bazooka in your pocket and people know it,” he said, “you probably won’t have to use it.” But bazookas can spook the very people they were supposed to reassure. After the plan was approved, foreign central banks slashed their Fannie and Freddie bond purchases by more than 25%, and shareholders rushed to dump their stock. On August 22, Moody’s downgraded Fannie and Freddie’s outstanding preferred stock by a full five notches, from A1 to Baa3 (or slightly above “junk”), and their Bank Financial Strength Ratings from B- to D+ (a one-half notch above D, something reserved for companies in default). Since the private sector isn’t buying, the Treasury is likely to wind up capitalizing the companies by buying new stock itself, seriously diluting the value of existing shares. A government bailout would be expected to wipe out the common shares, but it is becoming increasingly clear that the preferred stock is in jeopardy as well, jeopardizing the banks that hold it. There are other aspects of Paulson’s bailout plan that could be giving policymakers Maalox moments. As noted in a July 17 Economist article:
The U.S. federal debt is already up to nearly $10 trillion, putting its own triple-A credit rating in jeopardy. If the U.S. assumes the GSEs’ weighty liability as well, the country could lose its own triple-A rating, causing foreign lenders to withdraw their massive infusion of funds.3 But if the U.S. does not back the GSEs’ debt, the result could be the same. China’s $376 billion of long-term U.S. agency debt is mostly in Fannie and Freddie assets. Yu Yonding, a former adviser to China’s central bank, warned on August 21:
The Endgame Nears It sounds pretty grim, but let’s think about that. Would the end of the current financial system really be so bad? The international financial system is now controlled by a network of private central banks that print national currencies and trade them with sovereign governments for government bonds (or debt). The bonds then become the basis for creating many times their value in loans by commercial banks. At a 10% reserve requirement, banks are allowed to fan $1 worth of reserves into $10 in loans, effectively delivering the power to create money into private hands. The price exacted by this private money-creating machine is compound interest perpetually drawn off the top, in a Ponzi scheme that has now reached its mathematical limits. The chief role of Fannie and Freddie has been to keep the Ponzi scheme alive by adding “liquidity” to markets, something they do by buying mortgages and bundling them together as securities that are then sold to investors. Old loans are moved off the banks’ books, making room for new loans, further expanding the money supply and driving up home prices. As economist Michael Hudson noted in Counterpunch in July:
Bailout or Conservatorship? Under current law, if the GSEs’ capital falls too far below required levels, the Office of Federal Housing Enterprise Oversight (their regulator) is authorized to take control of the firms and impose a conservatorship, a form of bankruptcy. As former Federal Reserve consultant Walker F. Todd explained in a July 23 article:
Prior claimants satisfy their claims against available assets according to seniority, with lenders being senior to shareholders. The proceeds from any new business are kept separate. Fannie and Freddie investors would take some losses, but the available pot for settling claims is quite large. As Hudson observes:
Nouriel Roubini is Professor of Economics at New York University and has a popular website called Global EconoMonitor. He estimates that the haircut for securities holders would be a modest 5% ($250 billion on $5 trillion). Securities holders are getting a subsidy of $50 billion a year over what they would earn if they had invested in U.S. Treasuries, specifically because Fannie and Freddie carry more risk; and risk means the occasional haircut. Roubini concludes:
Nationalization Without Taxation: Successful Historical Models Roubini suggests that nationalizing Fannie and Freddie would require an increase in taxes or cuts in other public spending, but there are other possible funding solutions, ones with quite successful historical precedents. If the multiple layers of profiteers, speculators, derivatives, commissions, bonuses, fees and general fraud were eliminated from the mix, a nationalized Fannie/Freddie could finance itself. This was proven in the 1930s with the Home Owners’ Loan Corporation (HOLC), a government-owned agency set up to reverse a disastrous wave of home foreclosures. The HOLC was funded by the Reconstruction Finance Corporation (RFC), another wholly government-owned agency that performed the functions of a public bank. The RFC successfully funded not only the New Deal but America’s participation in World War II. In a February 2008 article in The New York Times, Alan Binder recommended a return to the HOLC model as a way out of the current mortgage crisis. He wrote:
The RFC initially capitalized the HOLC by buying all of its stock for $200 million. The HOLC was then authorized by statute to issue ten times that sum (or $2 billion) in tax exempt bonds. In the same way, in 1937-38 the RFC created and funded Fannie Mae as a wholly government-owned agency, for the purpose of injecting money into the banking system so that banks could increase the volume of home mortgages. The RFC and its agencies funded their operations by selling bonds at a modest interest to the Treasury and the public, then relending the acquired funds at a slightly higher interest. The “spread” was sufficient to cover operating costs and losses from default and still turn a modest profit. How did the HOLC manage to reverse a far worse foreclosure crisis than we have today and still turn a profit, when Fannie and Freddie – which also raise their loan money by selling securities to investors – have become hopelessly bankrupt in that pursuit? The difference seems to be that the HOLC was a public institution operated as a public service. Fannie and Freddie are private, profit-making ventures designed to make money for their investors and political exploiters. As Professor Roubini observes, “These GSEs were designed to make losses. They are expected to make losses. If they don’t make losses they are not serving their political purpose.” When the profiteering is taken out and the business is run as a public service, the math works. There is another American model that is even older than the HOLC, which presents even more exciting possibilities. In the first half of the 18th century, the province of Pennsylvania completely funded its government without taxes or debt, through a publicly-owned bank that issued paper currency and lent it to farmers. The bank did not have to borrow capital before it made loans; it just created the currency on a printing press. The money was lent rather than spentinto the economy, so it came back to the government in a circular flow, avoiding inflation; and interest on the loans was sufficient to fund the government’s operations without taxation. Such a public bank today could solve not only the housing crisis but a number of other pressing problems, including the infrastructure crisis and the energy crisis. (See E. Brown, “Sustainable Energy Development: How Costs Can Be Cut in Half,” webofdebt.com/articles, November 5, 2007). Once bankrupt businesses have been restored to solvency, the usual practice is to return them to private hands; but a better plan for Fannie and Freddie might be to simply keep them as public institutions. In the August 8 London Tribune, British MP Michael Meacher proposed this alternative for Northern Rock, a major British bank that was recently nationalized after becoming insolvent. He wrote:
Perhaps we should not return Fannie and Freddie either.
Ellen Brown, J.D., developed her research skills as an attorney practicing civil litigation in Los Angeles. In Web of Debt, her latest book, she turns those skills to an analysis of the Federal Reserve and “the money trust.” She shows how this private cartel has usurped the power to create money from the people themselves, and how we the people can get it back. Her eleven books include the bestselling Nature’s Pharmacy, co-authored with Dr. Lynne Walker, and Forbidden Medicine.
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Ellen Brown is a frequent contributor to Global Research. |
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