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Tuesday, July 15, 2008

The Emerging US Debt Crisis -- From Wall Street To Main Street By Way of Washington
James S. Henry

For those of you who haven't been paying attention in class lately, in the last two weeks the US economy appears14_bern to have been stumbling along the very precipice of an enormous debt crisis. 

As George Soros said this week, this may be "most serious financial crisis of our lifetimes" -- the worst since the S&L bailouts of the 1980s, and quite possibly since the Great Depression.

Depressionheadlines_2 Of course the apocalyptic,  self-hypnotic Mr. Soros has been over-predicting the penultimate "crisis of global capitalism" since at least 1987, when his first book, "The Alchemy of Finance," appeared. He also has a long history of profiting from short-side bets and Black Fridays.

However, the potential scope of this current US debt crisis is indeed enormous.  The ultimate cost to taxpayers of the associated bailouts will almost certainly make the $29 billion March 2008 Bear Stearns bailout look like batting practice.


We already knew that the American economy was suffering from soaring energy and food prices, rising unemployment, and falling house prices, with several mid-sized banks at risk of failure.  At least 2.5 million would-be homeowners are headed for mortgage foreclosures in 2008,  credit card, auto loan,  student loan, and home equity loan repayment problems have soared, and millions of ordinary citizens are discovering the high costs of not being "too big to fail." 

Since early July, however, the continuing collapse of the housing market, on top of mounting debt problems in other sectors,  has helped to produce a growing loss of confidence in many larger financial institutions, and bouts of near-panic and wild volatility on Wall Street. 

Indeed, the crisis may now pose a "contagion" risk to a wide variety of companies with household names, like GM,  Ford, and Chrysler, Citigroup, BankAmerica, Wachovia, Wells Fargo,  Washington Mutual, investment banks like Lehman Brothers  and UBS,  airlines like US Air, Delta, and American Airlines, and debt-ridden hotel chains like Hilton.


The crisis may also threaten the solvency -- refinancing ability -- of Fannie Mae and Freddie Mac, two gargantuan "government-sponsored enterprises" (GSEs)  that have long been treated by investors as virtually risk-free, despite having private shareholders, private sources of capital, and no official government guarantee for their enormous debt. 

Most Americans have probably never heard of these two giants.  But they  are at the very heart of the $21 trillion (capital) US housing sector. Originally there was just Fannie Mae, created in 1938 as a government-owned monopoly to add liquidity to housing and help realize the peculiar American desideratum of "every man a king in his own  castle" -- as if renting castles or otherwise sharing their use might not sometimes be a wiser resource of national resources.

Of course this social objective soon proved to be extremely popular with a vast coterie of private interest groups -- including land owners, developers, builders, building supply companies, real estate agents, architects and engineers, landscapers, title companies, insurers, and real estate law firms, not to mention the private banks, credit unions, and savings and loan associations that usually provided the first line of lending for home mortgages, as well as the Wall Street investment banks that stood to take a nice cut out of  assembling the private capital required for this venture.

In principal, the US Government might have simply declared that in order to achieve the noble goal of universal home ownership, it would provide direct government loans to homeowners, or, even better, just subsidize new house purchase with direct grants or tax credits,  leaving the rest of the program to private housing markets to sort out. But this simple, direct approach smacked of "socialism," which every interest group, lobbyist, and Congressmen in Washington instinctively just new to be hopelessly inefficient.

The elegant alternative designed and pursued with the support of all these various interests was to have the US Government remain in the background as much as possible. Except for low-income people and veterans, which the private interest groups didn't much care about servicing anyway, it would channel most of its subsidies for mass home ownership through two vehicles -- providing (2) a tax deduction for "home mortgage interest," and (2) creating a "secondary market" for mortgages, where banks could easily sell off loans they had issued, in the interests of encourage them to issue still more.


Forty years later, in 1968, a fateful Presidential election year, Lyndon Johnson faced a budget deficit because of the high costs of the increasingly-unpopular Vietnam War. Rather than raise taxes and stoke this opposition,  he decided to use "off-balance sheet" gimmicks to reduce the US Government's deficit.

One of these was to half-privatize Fannie Mae,  turning over ownership to private shareholders, hiring a coterie of very well-paid managers whose remuneration depended in large part on FNM's stock price, and sourcing more than 98 percent of its capital by floating bonds to non-USG investors.

At the same time, since it was just too much of a blatant goody-grab to privatize Fannie Mae as a monopoly,  Johnson  and the US Congress also created Freddie Mac to compete with it. Most economists usually don't expect to see much "competition" from an unregulated private duopoly like this one -- indeed, quite the opposite. But it must have seemed like a good idea at the time, especially to  Congress, Wall Street, and the other interests at the trough,  which stood to profit enormously from these two new bureaucracies.


Thirty years later, at least  from a certain standpoint, all these maneuvers have succeeded beyond their proponents'  wildest dreams.

First, for better or worse, more than 70 percent of American families now own their own homes, or at least possess them so long as they can still afford to service their mortgages.

True, we might well now permit ourselves a few second thoughts about the sustainability of the resulting overall pattern of urban development.  Many single-family homes,  for example, were constructed to take advantage of artificially-cheap mortgages, temporarily-cheap energy, heavily-subsidized roads, and temporarily-abundant open spaces.  In the wake of our rising energy costs and climate crisis,  the resulting low-density, highly-distributed network of isolated, oversized, energy-inefficient housing has become an urban planner's nightmare -- and yet another reason why Americans are experiencing so much frustration with their current "high-cost" lifestyles.

Second, the influence, economic and political,   of the two giant pro-housing GSEs has grown way beyond what anyone ever expected. 

They now guarantee more than $5.3 trillion of mortgages and related securities,  almost half of all mortgages outstanding. Treasury Secretary Paulson's plan to secure their stability by having Congress approve an unspecified US government credit line to them may or may not be a successful stop-gap -- the US budget deficit is already likely to exceed $500 billion this year, even without it.   But at least the Paulson approach would stop short of the risks posed by outright nationalization --  if US Government were forced to guarantee all this debt, this would nearly double the size of the public national debt overnight, and expose the  Treasury to much larger losses on this "underwater" mortgage portfolio.

Furthermore, the central banks of countries like China,  Japan, and Russia hRedinkave also accumulated at least $1 trillion of Freddie Mac and Fannie Mae debt,  on top of $3.8 trillion  of US Treasury liabilities that is held by foreigners -- including 57 percent of long-term Treasury bonds.

China alone reportedly holds more than $600 billion of GSE debt, one fifth  of its $3.25 trillion national income.

More generally, the US current account deficit is now close to 5 percent of GDP, and may even soon start growing again relative to national income, further increasing  dependence on foreign capital.

So this is no longer just a good old-fashioned “domestic US”  debt crisis by any means. Since the US is (still)  the world’s largest market, the engine of growth for many developing countries, and a traditional  safe haven for investors and central banks all over the world, this may turn out to be the world’s first truly global debt crisis, affecting rich and poor countries alike.

Once we add up the potential  losses  of global wealth and income, if it were allowed to get out of control, it could easily dwarf  the “S&L” debt criss of the 1980s, the Japanese debt crisis of the 1990s, and perhaps even the $4 trillion Third World debt crisis, where ultimate debt relief has totaled just $310 billion.Uschinaukstocks

Not surprisingly, stock markets in China, Europe, and Japan have recently followed US stock markets into the tank.


It used to be a rule of thumb that whenever a Mexican or Argentine Finance Minister found it necessary to declare more than once a week that his country's currency was "really sound" and not about to be devalued, it was time to short the currency.

During the second week of July we were treated on at least three separate occasions to assurances by  Treasury Secretary Paulsen, Federal Reserve Chairman Bernanke, and the head of the FDIC that the GSEs and  the vast majority of US banks really are "well capitalized" and nowhere close to  failure.

Judging by their recenBusinessloant performance,  these officials are having a tough time just keeping up  with the pace and scope of this crisis.

Their job is complicated by the fact that this is an election year, when politicians are especially reluctant to take actions that would offend key constituents

This includes like Fannie Mae and Freddie Mac themselves, for example. Since 2000 they have spent more than $190 million on lobbyists to press Congress and the White House for looser lending standards and weaker capital requirements.

They have also marshalled their allies on Wall Street, where investment banks receive hundreds of $millions each year in GSE underwriting fees; scores of real estate law firms across the country that live off the droppings of the FNM/ FRE mortgage documentation; and pro FNM/FRE "homebuyers" groups in every Congressional district. 

Needless to say, all this influence peddling has not ben used to secure regulations that might constrain FRE/FNM growth and profitability. After all, even  senior managers and stockholders of GSEs want to get rich.


After two decades of financial deregulation and the growth of this powerful "housing-finance complex," therefore,  all that was needed to create the speculative bubble and the spectacular bust that we've just seen was a compliant Federal Reserve and yet another Texas President who was reluctant to raise taxes to finance yet another unpopular war.

So, another 40 years later,  we have inherited the very same combination of burst bubbles and excessive debts,  heavily financed abroad and wasted at home, that we usually associate only with "submerging markets" in Latin America, Africa, and Asia.

Let's just hope that this time around,  our newly President will have the intestinal fortitude to clean up these Augean stables when he takes office in January 2009.  Otherwise we will continue to be plagued by  self-interested deregulation -- on top of natural disasters like housing slumps, oil price spikes, and war-like Presidents from Texas. 

(c) SubmergingMarkets, 2008    



July 15, 2008 at 03:09 AM | Permalink


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The Emerging US Debt Crisis -- From Wall Street To Main Street By Way of Washington
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