By G.L.C., on October 9th, 2008
The Federal Reserve was created 95 years ago to prevent banking crises as an independent agency whose Washington-based governors are appointed by the president of the United States and confirmed by the Senate. Its officials usually steer clear of the most heated political debates in a bid to protect their freedom to make the tough decisions required to keep inflation under control. There’s a good reason for giving the Federal Reserve so much independence. Decisions about the stability of the financial system often require quick decisions in times of crisis.
Ever since the credit crisis started in August 2007, the Federal Reserve has been engaged in a few political actions involving tax payer risks: asking Congress to approve Treasury Secretary Hank Paulson’s $700 billion bailout plan, agreeing to lend $85 billion to American International Group, taking on $30 billion in illiquid Bear Stearns assets to facilitate its take over by J.P.Morgan Chase, and helping engineer the federal takeover of Freddie Mac and Fannie Mae, which could cost the Treasury over $200 billion.
The political role being played by the Federal Reserve is setting a dangerous precedent: unelected officials deciding, without congressional votes, which companies and industries should be aided by its nearly $1 trillion balance sheet and which should be left hanging. The Federal Reserve is committing so much taxpayer money on its own rather than having Congress or the executive branch commit it. Its new roles of overseeing Wall Street investment banks and the AIG loan portfolio, among them, may bring it into conflict with the job of managing monetary policy.
The Federal Reserve has been using government funds and its credibility in its attempts to end the credit crisis. This increasing political role of the Federal Reserve could put its hard won independence at risk. Its independence is crucial to setting the interest rates that guide the economy.
The Federal Reserve probably did not want to be seen in a political role, but it had no choice – charged with maintaining the stability of the financial system and the economy, it had little choice but to take aggressive action in the face of a potentially devastating crisis. It was watching a falling knife and had to grab it before it landed on somebody’s chest.
Any proposals to change the Federal Reserve’s role would face fierce opposition. Because of the actions it has taken so far in trying to save Wall Street firms, if it comes under attack, Wall Street will be among its main supporters. It will also have the support of an army of loyal bankers around the country.
Everything depends on how the economy emerges from the present credit crisis. If it stages a steady recovery, it will increase the credibility of the Federal Reserve and there will be less concern about its political role.
By Evelyn Black, on October 8th, 2008
The U.S. stock market has been nothing if not volatile this year, especially over the course of the past few weeks. As the current credit crisis tightened and the world watched in horror, what most people saw was the stock market spiking and plummeting, often on mere rumor and speculation, and sometimes on the strength of what seemed like nothing at all. We’ve gotten used to this show, and for many people, it has become a source of rage and disgust.
The 777 point plunge in the Dow Jones Industrial Average after the defeat of the House $700 billion rescue package was dramatic and scary. By most accounts, about $1 trillion was lost in a single afternoon. I personally lost a quarter of my 401(k). The very next day, however, more than half of that loss was recouped on the mere hope that some kind of bill would in fact pass by the end of the week, even though it was impossible to know what kind of bill that might be.
Meanwhile, radio talk shows were busy interviewing everyone who had ever held any kind of opinion about anything related to finance, and some of it was not just misleading, it was nuts.
For instance, at one point I heard the crisis described as something that would “…make it harder for people to get car loans and would also cause small businesses to have to use their credit cards instead of lines of credit with their banks.” At the other end of the spectrum was a semi-hysterical comment by a cable news pundit who said, “People want to know if they will be able to use their ATMs by the end of the week!”
Both of these remarks are misleading.
First of all, the ATM issue is not an issue. Sometimes ATMs don’t work even when there isn’t a credit crisis. The things actually run out of money sometimes, often on Sundays, and on top of that they are subject to computer software glitches, mechanical breakdowns, and all sorts of other gremlins that are just part of life. Stuff happens with ATMs, and the credit crisis is not the kind of “stuff” that happens to them. It’s not related at all. You have no more reason to worry about your favorite ATM now, this week, than you ever have.
So calm down.
The other remark is just as misleading though. If auto loans are harder to get and business trips are put off, that’s bad for the economy, certainly. But explaining the credit crunch this way gives the impression that it is something that will just make people tighten their belts a bit, and tightening our belts is something that the overwhelming majority of us feel is long overdue and probably a good thing. I have noticed a real effort on the part of the media not to scare people. Fine. But let’s be honest at least.
The real scare with a credit crunch has nothing to do with your purchasing habits and everything to do with the fact that so many businesses, including big banks, run on short term credit. By short term I mean a day, a week, sometimes a month. A business needs this credit to even out cash flow so it can function properly. So, for instance, the garden center where you work as a clerk probably makes about 80% of its money in May and June. The rest of the year, your paycheck is likely written on a line of credit from the bank. This is true of many businesses, especially retail and construction. Profit is not spread evenly over twelve months.
Free flowing credit is good for business because, over the course of a year, if a business still makes lots of money during that May and June flower frenzy, they will turn a profit and stay current on their short term lines. The bank stays happy, the business stays happy, and you stay employed and get paid in checks that don’t bounce. You take those good checks to your bank and spend the money on stuff, and the world goes round and round like it should.
When credit gets too tight, it’s like throwing a wrench into the gears of that whole system, and commerce grinds to a halt. When commerce grinds to a halt we get a recession, or worse.
That is the fear that is behind the current attempt to “rescue” the U.S. financial system fast, but it is just abstract enough to be a non-issue for the average person. We all see that DJIA looping up and down like an out-of-control hang glider, and we think, that’s nuts. Those guys deserve to fail.
What is harder to understand is that, if those guys fail, they will retire to their homes in Martha’s Vineyard and Connecticut and Vale, and we will lose our jobs and wait in line to buy milk because, if you don’t buy it on the day it comes in, you don’t get any.
I believe that the truth is that that might happen anyway, no matter what Congress does or doesn’t do. But I also think part of the problem right now is the complexity of the situation and opaque nature of the mess our economy is currently in. The stock market is only the thermometer, and it seems to be a broken thermometer at that: One that works sometimes and other times seems completely, psychotically detached from any day-to-day reality.
The excesses of the financial world and the real estate bubble have left us with a loss of trust in our leaders and our business, and they in turn have all lost trust in each other. Nothing good happens financially in an environment in which there is no trust, and once lost, trust is a very hard commodity to lay one’s hands on.
So it’s no wonder that the American people are overwhelmingly against any government intervention in this historic economic mess. What is frightening is that by the time people do realize that this mess is going to hit them personally, and hit them hard, it may well be too late.
By J.D. Seagraves, on October 7th, 2008
Evelyn Black wrote a great blog on September 26 explaining the financial inter-connectedness of the U.S. and China. To sum it up, she says that the U.S. imports more from China than it exports to China. This difference, the trade deficit, is made up by the Chinese government’s investment in U.S. government debt. In other words, China trades the U.S. real goods in exchange for paper promises. Now, as the assets backing those paper promises (housing prices in the case of mortgage-backed securities, “full faith and credit” otherwise) are depreciating in value, China’s government is in a pickle. If it dumps its U.S. dollars and dollar-denominated debt instruments on the open market, the value of those assets will fall further and faster. But holding them as they depreciate isn’t an attractive option, either.
I’d like to expand on Evelyn’s article and answer these questions: Why the heck would China put itself in this predicament? Why trade real goods for paper promises? Why put so much faith in the value of the Federal Reserve Note (FRN) and in the ability of the United States’ central bank to maintain the value of dollar-denominated assets?
As a developing (nearly developed) country transitioning from socialist central planning to a market economy, China has relied on the U.S. dollar as a means of stabilizing its own domestic currency, the yuan. For a long time, the yuan was pegged directly to the dollar so that its value went up or down with the FRN. But the U.S. Congress viewed this as “currency manipulation” and threatened high tariffs against Chinese imports if the yuan weren’t revalued. In other words, Congress demanded that China make the U.S. dollar weaker vs. the yuan, which would diminish the trade deficit – at least on paper.
Ever since the end of World War II, when the international gold standard was abandoned, the U.S. dollar has served as the world’s reserve currency. It has been the most stable and widely accepted of the world’s fiat money. But years of monetary expansion have eroded the FRN’s value, and the policies of aggressive debasement of Alan Greenspan and Ben Bernanke have led us to the place we find ourselves today: with the dollar rapidly losing its status to the euro.
What prevents China from switching out of the dollar and into the euro? Again, it holds too many dollars and dollar-denominated assets to make the trade without severely throwing the relationship between the dollar and the euro out of whack. Many other governments are in a similar quandary. And the U.S.’s military dominance still holds sway, particularly over petroleum-exporting countries who are literally forbidden from accepting anything other than the U.S. dollar in exchange for barrels of oil. Just ask Saddam Hussein.
Evelyn said it best when she called the U.S. financial system “Orwellian, bizarre, and unbalanced.” Another word she could have used is “unsustainable.” How and when the system will come crashing down remains to be seen, but my bet is that it happens sooner than most of us are are expecting.
By Stephan Zimmermann, on October 6th, 2008
Several questions during the last few days pointed out the obvious: lost in the media coverage of the American financial crisis and the tail end of the presidential election seems to be the fact that there really is news beyond Wall Street and Main Street.
I could not agree more.
For example, how much attention has been paid to the fact that our closest neighbor, Canada, is having its 40th parliamentary election on October 14?
Neither the Liberal nor Conservative Party has a majority in the parliamentary system.
The economy, of course, is topmost on the agenda.
In the Toronto Star, the paper raised the question whether Canada is likely to experience similar problems in its housing boom. The upsurge in housing lasted for more than ten years, although it has somewhat cooled off even before the Bearn Stearns, Merrill Lynch, Lehman Brothers, and AIG debacles.
According to Jim Adair of Realty Times,
Tighter lending guidelines for developers and a lower level of investor participation have reinforced a more cautious approach among home builders. …Households, for their part, are not over leveraged. Home equity as a share of real estate assets has been steadily building this decade, as price appreciation outpaces the rise in mortgage obligations. Canadian households also have little direct exposure to sub-prime lending, which has accounted for only about five per cent of domestic mortgages in recent years, compared to over 20 per cent in the United States. (www.realitytimes.com)
Reflecting the fears and uncertainties of Wall Street, however, the Toronto stock exchange (TSX) on October 2 saw a fall of more than 800 points, following on the events of Monday, September 29.
Further adding to market malaise,
On October 1, 2008, the United States Securities and Exchange Commission issued Release No. 58703 announcing the extension of the temporary easing of restrictions on issuers repurchasing their securities. Issuers listed on a U.S. national securities exchange (U.S. Exchange) are temporarily exempt from the application of certain share repurchase rules under the Exchange Act Rule 10b-18. TSX has granted and is extending similar temporary relief to TSX listed issuers that are also listed on a U.S. Exchange. (www.tsx.com)
That SEC rule extension virtually encourages Canadian companies to repatriate subsidiaries with U.S. exposure.
Other key items on Canada’s election agenda include the environment, the arts, infrastructure, and the nation’s role in Afghanistan.
Unlike the United States with it two-party political system, Canada’ multi-party parliamentary structure assures that dissident or minority parties’ concerns are widely aired. The dual-language nation also airs its major parties in both French and English debates. Interestingly, while some 30% of Canadians didn’t plan to listen to either the Canadian or the American vice-presidential debates, more than 60% of those polled had planned to watch both. The debates were both aired on October 2.
Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. If you would like Stephan to answer your economics-related questions, read his post “Got an Economics Question?” and submit your questions in the comments area there.
By Evelyn Black, on October 1st, 2008
When I was a kid (I’m 55 now), I looked forward to holiday dinners because that was when my parents and my grandparents held their traditional “Was FDR a scoundrel or a savior?” debate. My grandparents, who worked for public utilities and, thus, survived the Great Depression with conservative opinions intact, argued for FDR the scoundrel. My father, who worked for a public utility company on the blue collar side and was a union steward, argued for FDR the savior.
The FDR argument was a traditional debate in our household even though the issue itself was a historical one, and though I already knew what every single participant was going to say, I looked forward to it because it was so exciting to see people I loved all vehemently disagreeing without really hurting each other. That’s the democracy I saw as a kid and the one that I miss today; a democracy that encouraged informed debate and tolerated strongly divergent views.
Watching the wrangling in Washington over the current banking crisis reminded me of that debate. The holidays are approaching, lots of Americans are scraping for turkey money, and, in an effort to maintain calm, the press is trying hard to replace the “D” word (Depression! Run for your lives!) with the more awkward but also more calming phrase “possible severe recession.” Once again we are witnessing an autumnal debate about the role of government in business and financial markets. Once again we are witnessing the spectacle of a televised tag team match between Emergency Socialism and Unfettered Capitalism.
Was FDR a scoundrel or a hero?
I don’t know. I do know that our current economic situation is similar in some ways to the one our grandparents (or in many cases, great-grandparents) survived. The stock market collapse that kicked off the Great Depression in 1929 came at the end of a bubble that included high-rolling, unfettered speculation and wildly indulgent personal lifestyles. The Dust Bowl disaster of the 1930s is parallel in some ways to our current climate change and energy crisis, with the displacement and disenfranchisement of huge numbers of people due to Katrina and now Hurricane Ike, and the promise that these kinds of monster storms will most likely become the norm, not the exception.
Like working Americans during the Great Depression, working Americans today are witnessing a rapid increase in costs concurrent with wage stagnation. Unemployment, while nowhere near Depression era levels of 25%, is rising rapidly and will rise even more rapidly should the current credit crunch continue. Just as in the aftermath of the stock market crash of 1929, we have a Hoover-like presidential candidate and an FDR-like candidate, acting out their respective roles in the holiday FDR debate on the national stage.
But there are real differences between our current situation and the one FDR seized by the horns in the ’30s.
The first difference is that American industry was still strong in the 1930s, and gearing this industrial base up for WWII arguably helped FDR turn the country around. Now, not only is U.S. infrastructure shot, our industrial base is gone, too, shipped overseas by multinational corporations in the wake of NAFTA for better profit margins.
A second difference is a loss of skills in the general populace. While my grandmother loved to regale me with stories about how she walked six miles for a 20 pound sack of government-issued potatoes once a week and fed her family of six on that and not much else, today’s consumer would be hard pressed to know what to do with a potato if there wasn’t a Wendy’s nearby. While we can relearn these skills (and many are doing just that: agricultural markets are “ripe for picking,” so to speak, and purchase of vegetable seed skyrocketed this year), in the short term, we have lost a lot of self-reliance and capability as individuals.
But maybe the most striking difference between that time and this one is the lack of a unifying political vision. My parents and grandparents argued about FDR at the Thanksgiving dinner table in part because FDR, scoundrel or hero, was able to bring everyone together for the common good, at least for awhile. Today, we have political machines that are still feeding the culture war in America, drawing a line between red and blue and even underhandedly pitching to white – something we all hoped we were past but clearly are not.
Who has the 21st century New Deal for America?
Hank Paulson doesn’t. But between the stock market’s meltdown after the House rejected Paulson’s bailout plan on Monday and tonight’s Senate vote on their version of a financial rescue package, we are finally hurting bad enough to come together to fix the mess wrought by 25 years of free market capitalism. Even then, freeing up U.S. credit markets will not in and of itself stop the free-fall in home values and home sales. It will do nothing to bring back the tax bases of our major cities. It will not encourage energy independence or investment in U.S. industry and infrastructure, and it will not address the problem of declining wages and rising costs.
Finally, helping Wall Street get its credit markets back on track will not bring together a populace split down the middle over issues of religion and personal lifestyle. It will not stop the feckless political pandering that has brought us to this sorry state.
I think we do need a New Deal, a vision of where America wants to go and who America wants to be on the world stage. Until that emerges, we will be seen only in terms of what we once were, and our suffering will continue. Debt cannot be a nation’s only commodity if that nation intends to prosper.
The parallels to our time and the time of the Great Depression are there alright.
But we haven’t seen anything, yet.
By G.L.C., on September 30th, 2008
In the late 1970s, the total compensation of chief executives in large American corporations was 35 times that of the average American worker. In 1993, Congress limited the tax deductibility of executive salaries to $1 million unless it could be demonstrated that the extra pay was linked to performance incentives. This contributed to the practice in later years of very generous grants of stock options, which helped drive executive pay to new heights. According to an estimate by the liberal research organization the Economic Policy Institute, in 2007, an executive’s salary was 275 times that of the average worker.
Wall Street executives, with their eight figure earnings, are at the top of the corporate pay range. Wall Street firms have a bonus system which rewards short-term trading profits. It acts as an incentive for executives to expand their highly profitable businesses in exotic securities and ignore the risks. The present financial crisis is a direct result of the compensation practices at these Wall Street firms, which encouraged executives to maximize profits and ignore risks. The salary levels at some Wall Street firms are appalling, given their performance. After news of the bailout plan spread on September 19, experts felt that it was only reasonable to impose limits on the salaries of executives of firms that would participate in the bailout. It was they who made those risky bets on behalf of their firms.
As Congress and the Bush administration (represented by Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke) deliberated the bailout plan before it was rejected by the House on Monday, lawmakers felt that executives should not be allowed to walk away enriched, especially since many have contributed to the present crisis by taking too many risks. There were calls to impose some limits or approval authority on salaries of executives whose firms seek help.
Presidential candidates Barrak Obama and John McCain have both called for limits on the salaries of such executives. There is a fear among many, including lawmakers, that Wall Street’s tarnished titans might walk away with tens of millions of dollars a year while taxpayers pick up the tab.
A Senate draft document calls for a ban on incentive payments that the Treasury deems “inappropriate or excessive” and a “claw-back” provision requiring an executive to give up pay or severance benefits if the firm’s financial results are later shown to be overstated. Other proposals call for a ban on severance payments and allowing large shareholders, with a stake of 3% or more, to propose alternative slates of board directors. This would be an effort to tackle excessive pay practices by opening up and strengthening corporate governance.
Opponents of the proposals say that pay restrictions will discourage hard work and innovation. It would have an overall impact on the financial sector and the economy. Some feel that it would be best to stretch out payments for several years, encouraging executives to pursue the long-term health and stability of the firms they head. However, the salaries are bound to fall. With consolidation, more people would be competing for fewer jobs, leading to lower salaries.
By Evelyn Black, on September 29th, 2008
“OK, everyone, stay calm. Hand over the $700 billion right now, and no one gets hurt. Make a wrong move, and the whole economy goes down! Make it quick, or you can all kiss your retirements good-bye!”
Dialog from an old-fashioned “stick-em-up” Western? No, actually, this drama was playing out in real-time Congress last week as Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and President George W. Bush promoted a $700 billion financial bailout plan to Congress and, I might add, a mob of very angry constituents. The drama ended today with the House of Representatives voting to reject the plan.
Paulson’s bailout plan has forced Main Street and Wall Street into a really ugly confrontation, and if you think I’m overstating this, read the comment sections attached to the New York Times editorials. Those comments are running at around a thousand or more each day. Wading through them, I found not one that said anything remotely resembling, “Thanks Hank! What a great idea! Thank goodness we have a smart guy like you in charge at a terrible scary time like this!”
Before rejecting it, Congress had managed to negotiate some governmental oversight to be added to the plan (the original bailout deal specified no oversight allowed and complete immunity from prosecution) and also negotiated the addition of some provisions for helping homeowners in foreclosure refinance and stay in their homes. Still at issue were CEO salaries and consequences for banks and lending institutions that avail themselves of the Paulson plan to buy up the worst junk on their books: mostly dubious and impossible-to-value mortgage-backed securities, credit default swaps, and other weird, overly creative investment vehicles that threaten to bring the U.S. economy to a catastrophic halt.
What was emerging, as Paulson’s request sunk in, was an incredible amount of public outrage. Initially, the request was for Congress to push the bailout plan through in a day, if not sooner, or suffer dire consequences. It didn’t take long for the American public to start calling their representatives nonstop to let them know that they would, personally, rather suffer dire consequences than hand over $700 billion in taxpayer money to a Wall Street investment banker on the strength of two words: “Trust me.”
Putting dire warnings and assurances of fiduciary responsibility aside, there was no guarantee that this plan (which was literally cobbled together overnight) would work. Comparisons have been made between Paulson’s plan, or, as NYT columnist and Princeton economist Paul Krugman calls it, the “Cash for Trash” plan, and the Resolution Trust Corporation of 1989. The RTC took home mortgages seized during the savings and loan crisis of the late 1980s and sold the homes attached to those mortgages, eventually recouping some of the money lost in the S&L failures. The markets stabilized, and the RTC was widely credited for helping to get the economy back on track.
The original RTC took in $225 billion worth of bad assets and sold them for $140 billion over time, reducing the actual taxpayer cost of that bailout to around $85 billion. But the Paulson plan was widely expected to top $1 trillion for the initial purchases, and there is a big difference between the assets seized then, which were backed by real property, and the assets clogging the books today, which are so complex and poorly constructed that decoding what backs them and where that property might be has become a nightmare in its own right.
No one knows the actual value of these assets, or if they even are assets, and whether they will ever have any resale value. If they are purchased too cheaply, banks will have to declare large losses and may fail anyway. If they are purchased at too great a cost, it amounts to handing over taxpayer money to the very institutions that created the problems in the first place.
Acknowledging the difficulty in valuing and purchasing these junky securities, Paulson’s solution was to hire investment analysts from the private sector to broker the deals and to protect the brokers and the buyers under a cloak of immunity from scrutiny and prosecution. The appeal of such an approach for Wall Street is obvious. On September 19, stocks rebounded insanely, causing even sympathetic investors (the few that remained) to recoil in disgust. But what was the appeal to taxpayers?
The appeal was, “This will stop The Great Depression II from happening.”
Whether it will or won’t, Congress has killed the chance to find out. For now.
By Evelyn Black, on September 26th, 2008
If you watch the news at all these days (and a case could definitely be made for avoiding this habit), then you already know that the United States imports way more cheap stuff from China than it sends over there for sale to the Chinese people. That big difference between the huge amount we import and the tiny amount we export is called the trade deficit, and you’ve almost certainly been hearing for eight years now about how it keeps going up and how that isn’t such a great thing.
What you may not realize, however, is that the recent federal bailout of the mortgage giants Fannie Mae and Freddie Mac stems in part from the strange and delicate trade relationship the U.S. has forged with China; a relationship that consists of lots of imported Chinese goods that Americans buy up with money that is essentially loaned to the U.S. by, you guessed it, the Chinese.
The Chinese do not issue loans directly to the U.S. the way that a bank would issue a loan to an individual. What the Chinese government does instead is buy up U.S. debt, mostly in the form of mortgage-backed securities. The recent tax rebate stimulus package designed to get shoppers out and spending money again to shore up the flagging U.S. economy came largely from this kind of investment by the Chinese in the debt held by American financial institutions.
While it may seem circular and confusing to think of the Chinese actually loaning the U.S. the money to buy Chinese products, the fact is that right now the U.S. government is heavily dependent on this kind of Chinese investment just for the continuation of its day-to-day business. In other words, without Chinese money being poured into the U.S. in the form of securities purchases, our government would experience such a budgetary shortfall, it would have to shut down.
The linchpin in this arrangement, obviously, is U.S. housing values. If the value of the properties backing the mortgage debt purchased by the Chinese remains stable or increases steadily, everything continues to hum along normally (or at least normally on the surface of it). The Chinese have an asset they see as increasing in value (that is, American mortgage-backed debt securities), and the U.S. government has the money it needs for its day-to-day operations. The Chinese make money off of their exports to the U.S. and off of their investments in U.S. housing-backed debt, and U.S. citizens continue to consume the cheap Chinese goods we have grown accustomed to buying.
That’s the U.S. consumer economy in a nutshell, and if it sounds a bit Orwellian, bizarre, and unbalanced, that’s because it is. Nevertheless, that’s how we roll these days, or did, until the housing bubble burst and the values of the properties actually backing all this mortgage debt began to drop precipitously. At first it was only subprime debt that went bad, but that spread to what is known in the mortgage industry as Alt-A debt (which is a notch above subprime and once considered quite a safe risk).
Now even homeowners who are in no danger of defaulting on their mortgages are seeing dramatic drops in their property values due to a badly inflated housing market and the subsequent bursting of that bubble. And as if that isn’t all bad enough, the problem is rapidly spreading to other kinds of U.S. debt: credit cards, car loans, home equity lines, and small business lines of credit.
To put it in just a few words: the actual assets backing U.S. debt are now depreciating instead of appreciating in value, leaving the Chinese holding substantial investments in the U.S. that are looking less and less profitable. The Chinese have been friendly to the U.S. because they are making lots of money from the relationship. With the bursting of the housing bubble, not so much. They have been growing more and more nervous about this fact.
What does that have to do with Fannie and Freddie?
Fannie Mae and Freddie Mac back most of the mortgage debt in the United States, but because they have always had a quasi-governmental status, they have not kept the kind of prudent reserves on hand that a private financial institution would be required to keep to mitigate such losses. As it became more and more clear over the course of the past year or so that Fannie and Freddie didn’t have adequate financial reserves to back the debt they held, the Federal Reserve and the Treasury Department began to talk about a bailout.
It’s a bad thing that housing values are plummeting in the U.S., but it has to happen because they were so wildly inflated during the boom years. That hard correction would be painful for the U.S. no matter what, and we are certainly feeling the pain already in the form of a major economic turndown that looks like it will last at least through the better part of 2009. But what would be even more catastrophic than the pain we are already feeling in our collective national pocketbook would be a decision by the Chinese to pull back on their investment in us. Such a move would literally throw us into a financial meltdown that would make the Depression era look pretty cheerful by comparison.
So, while it may or may not be true that Fannie and Freddie “are too big to be allowed to fail,” what is unquestionably true is that the U.S. government is too big to be allowed to fail, and fail it would without a steady influx of Chinese money.
All of this is more food for thought that I can possibly digest in a single sitting. If you pay close attention to the expressions on the faces of Bernanke and Paulson, you may well detect a hint of dyspepsia there, too.
The day is saved. Again. For now.
And yet once again, in the smoking (and indigestible) aftermath, a familiar and phrase rears its ugly head:
“What next?”
By G.L.C., on September 26th, 2008
The present financial crisis – probably the worst in decades – is making the lawmakers in Washington, D.C., strongly consider the need to dust off a 1980’s era plan to help save the banking industry and stabilize the economy.
The idea of setting up a government corporation to deal with toxic assets has invoked strong interest among both Democrats and Republicans. Lawmakers are eager to find some solution to the crisis. Eleven banks have already failed this year, and there are questions surrounding the major financial institutions. On September 6, the federal government took over mortgage lending giants Fannie Mae and Freddie Mac as they teetered near collapse. Lehman Brothers has filed for bankruptcy. Merrill Lynch & Co agreed to sell itself to Bank of America. And the government has just bailed out American International Group, Inc., a financial behemoth.
The bailout of AIG, one of the world’s biggest insurers, cost the government $85 billion. Doubts remain whether the bailout will effectively help stem the ripple effect that failing banks and financial institutions are having on the economy. AIG’s cash squeeze is driven in large by losses in a unit separate from its traditional insurance business – the financial products unit, which sold credit default swap contracts designed to protect investors against default in an array of assets including subprime mortgages.
The Treasury Department is planning to sell bonds for the Federal Reserve in an effort to help it deal with the unprecedented borrowing needs resulting from the present financial crisis. And lawmakers are now appearing open to the idea of creating a government entity akin to the Resolution Trust Corporation (RTC). The RTC was formed amid the savings and loan crisis in the 1980’s. The RTC resolved and liquidated the assets of 747 thrifts with total assets of $394 billion.
What is needed is an institution or a mechanism of a supertrustee to handle incredibly large financial institutions which may be allowed to fail and how those assets get managed and ensure they are handled in an expeditious manner. The absence of such an institution or mechanism could in the future result in one failure after another. The failures will keep blossoming. Many lawmakers are calling the creation of such a mechanism a legitimate idea that merits consideration.
The creation of a new federal agency would only put taxpayers at risk for billions of dollars in bad debts. The parallels with the 1980’s are inexact. The mission of the RTC was to dispose of the assets as quickly as possible for maximum value and reduce taxpayer exposure. Unlike now, the government had no choice but to acquire the assets from savings associations because they were backed by federal deposit insurance. The mortgages, which are at the heart of the present crisis, are not backed by federally insured deposits.
By G.L.C., on September 23rd, 2008
In 1932, Congress created the Federal Home Loan Banks to prop up thrift institutions during the Great Depression. Today, there are 12 regional Federal Home Loan Banks. Their main business is low cost loans to their more than 8000 owners, which include commercial banks, thrifts, credit unions, and insurance companies. Like Freddie Mac and Fannie Mae, they are also Government Sponsored Enterprises, entities owned by private shareholders but chartered by Congress to perform a public mission. This special status enables them to borrow inexpensively on the bond market. Because of their special status, investors assume that the federal government would bail them out of any crisis.
The 12 regional Federal Home Loan Banks are among the world’s largest borrowers. They have about $1.3 trillion of debt outstanding. Ever since they have taken on a bigger role in funding banks and thrifts, their debt has ballooned 34% since the end of 2006 mainly because the credit crisis dried up other sources of funds for banks and thrifts.
The present credit crisis has already compelled the federal government to take over Freddie Mac and Fannie Mae. Many are now wondering if the federal government will eventually have to bail out the Federal Home Loan Banks as well. The Federal Housing Finance Agency, which overseas these home loan banks and acts as their regulator, is confident that the federal government will not have to step in.
Another worrying factor is that some shaky firms like IndyMac Bancorp, Inc., which was seized by regulators in July, also received advances from these home loan banks. But these advances are backed by collateral. When a bank fails, home loan banks have priority over other creditors, including the Federal Deposit Insurance Corporation.
Many experts have always criticized the concept of Government Sponsored Enterprise and called them flawed and unviable. The federal takeover of Freddie Mac and Fannie Mae have only strengthened this argument. Many are predicting that the Federal Home Loan Banks could be next. But it might just remain predictions.
Unlike Freddie Mac and Fannie Mae, the Federal Home Loan Banks have managed to remain profitable despite the present crisis. Their reported combined net income for the second quarter of the year is $718 million. This is a 14% increase from the figure for the same period last year.
But there are warning signs. One of them: the Federal Home Loan Bank of Chicago reported a loss of $152 million for the first half of the year. The loss was caused partly by hedging costs-related interest rate risks on mortgage investments. But the Chicago bank can take heart from the fact that another home loan bank – the Seattle Home Loan Bank – suffered a $9.1 million loss in the last quarter of 2005 but has since returned to the black. The loss in 2005 was also caused by mortgage investments.
These banks do not have publicly traded shares. Only the members or customers own shares in these banks, and these shares change hands only at face value.
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