The US economic crisis

Freddie, Fannie, and the Federal Reserve Note

New Deal monstrosities Freddie Mac and Fannie Mae have long insured mortgages with the implicit backing of the US Treasury. These government sponsored enterprises (GSEs) bought mortgages on the secondary mortgage market from originators and banks. This took financial risk out of the equation for originators, banks, and put it on the shoulder of gov't if gov't decided to honor its implicit guarantee. The implicit backing turned explicit when they were bailed out with taxpayer money.

Without fear of risk there is little to constrain greed.

To make sure F&F are not mistaken for private firms, the President of the USA picks five of their eighteen directors, as one example, not to mention their tax breaks and congressional charter. F&F have also been notorious for accounting fraud to boost executive earnings.

Foreign investors, like sovereign wealth funds and China’s state-owned banks, accounted for nearly $1 trillion of the $1.5 trillion of debt that F&F held as of August 2008. Foreign nations have begun to "diversify away from the dollar" in our hitherto core institutions, as have oil producing nations, and that puts even more negative pressure on our economy.

This is dollar hegemony at work. It’s one of the reasons why we strive to keep the dollar the reserve currency of the world, that is having foreign nations hold dollar denominated assets to provide liquidity (or cash) to our own markets, while our own dollar devaluation allows us to tax their holdings denominated in USD through monetary inflation. We tie them to our markets and therefore our fate but in so doing also tie our fate to their actions. As the dollar becomes weaker through monetary inflation they lose money/value and seek other foreign currency/assets.

(China Daily)
Updated: 2008-09-12 07:32

China, which holds a fifth of its currency reserves in Fannie Mae and Freddie Mac debt, may cut the portion held in US dollars, according to China International Capital Corp (CICC), one of the nation’s biggest investment banks.

The US government this week seized control of the two mortgage-finance companies, which account for almost half of the home-loan market in the world’s biggest economy, to prevent defaults from crippling them. China holds up to $400 billion in the two firms’ debt, CICC Chief Economist Ha Jiming said in a report Thursday.

"The crisis has made Chinese officials realize it’s a bad idea to put all their eggs in one basket," wrote Hong Kong-based Ha. "This will likely lead to greater diversification of foreign exchange reserve investments."

Bank of China flees Fannie-Freddie

Federal Reserve custody data shows that for the year to July, foreign official and private investors bought an average of $20bn of agency debt a month, including debt issued by other government agencies such as Ginnie Mae and the Federal Home Loan Banks. Purchases of US Treasuries averaged $9.25bn.

From July 16 to August 20, foreign investors sold $14.7bn of agency debt, trimming their overall holdings to $972bn. They purchased $71.1bn of Treasuries in the same period.

It's nice to Win when you Win and to Win when you Lose

Mortgage-backed securities (MBS) needed to be auctioned off with investors recouping whatever price they could get, eating the loss on their investment, just as any NORMAL investor (read: one not guaranteed by the US gov) would. The Fed and the Treasury essentially bailed out the MBS investors, not so much F&F itself (it would have been better to dismantle them), like China at US taxpayer expense. No free-market risk here for these investors, you (the taxpayer) covered their losses. Did you get a thank you card?

Home prices need to collapse even further, which would lower capitalization in the market and throw more people and firms into default BUT would return housing to an affordable and sane level to spur buying - while lo and behold bringing housing to market levels. The government decided to prop up home prices and recapitalize banks with taxpayer cash instead.

For those of you who support the bank bailout, the government could have taken the same amount of money and paid down a portion of the homeowner's mortgage (absolving them from the mortgage in part or in entirety) and accomplished the same deleveraging of risk with the same amount of money spent.

(more to come later)

FYI, I've been waiting for you to finish writing out your thoughts before I respond, fafyrd.

Thanks for waiting Mr Ni. If someone would like to post, let's start up anyway. I was gonna go on about the interest rate, that consumers and banks bore some responsibility, etc... I imagine the topic will be long if we have everyone posting.

It's a snow day; I'll be picking up my fiance and bringing her over here so I won't be online much at all today.

EDIT: If someone would like to post their own chronology or reasons as well, feel free!

Ok. The buzzword that's been tossed around in economic circles for the past year or so has been that this US economic crisis is a "crisis of confidence". Consumer confidence has reached all time lows and remains frustratingly low much to the disdain of retailers. The chart, while informative is misleading as the peak of September 07 coincides neatly with the peak in the housing bubble and likely investors hedging against the bubble popping. The only really insightful thing I can gleam from that chart is that it seems China got screwed when the US housing bubble popped yet still continues to bet that the US will remain the dominant economic force and is still buying US treasuries but at a more cautious level.

So the foreign nations believe the US is ok, but the all important question to US companies is, do we Americans believe the US is ok.

A couple more questions to consider. That chart shows % of US treasuries bought by foreign nations with China singled out. But that's excluding domestic purchasers which apparently is what many people seem to be flocking to right now (even though buying treasuries is not the best thing to do right now because of low interest rates) so are those US treasuries being left unsold? Are Americans buying up treasuries and picking up the slack from foreign investment?

I believe MBSs are what the media has dubbed as toxic assets, right? Well, those toxic assets are paying off handsomely and are part of the reason why the Fed has been so profitable last year.

Keeping Interest Rates Low

Chinese, and other nations especially Japanese, savings replaced American savings to act as a source of capital for monetary inflation in the US. The Asian currency pegs, informally called Bretton Woods II, kept the value of their currency low compared to the US dollar. This allowed the US to buy with relative value from China and gave China incentive to sell to the US. Niall Ferguson calls this relationship "Chimerica" in his book The Ascent of Money.

Bonds have to be paid back with interest. In borrowing from China and buying from China, the US ultimately got in a worse position. China held / is holding down their own currency appreciation (which would make their goods more expensive here) by sending our money spent on goods back to us to buy bonds. When this currency imbalance begins to move toward equilibrium (Chinese currency appreciating and US currency depreciating in relation to China's) the US will be hit harder than China as Chinese goods will become more expensive in the US. They can't hold down their currency forever and have bought less and less bonds as time went on.

US Treasuries are now being bought up by the Federal Reserve to continue to keep interest rates low and to offset the loss of treasury purchases by China and others. This is an example of how the US is monetizing their debt by printing money out of thin air. This isn't real capital, it's fantasy capital. By devaluing the dollar in this way, the government eases its own debt burden vs bond holders (both foreign and domestic) but will make average Americans, mostly the middle class, a LOT poorer in the process through monetary inflation that will cause prices to rise and salaries to lose real value.

Fed to buy Treasurys in attempt to boost economy The Fed - MarketWatch (July 2009) one example

To digress briefly, a free-market interest rate would be set by the competition of overall savings from any source. Generally, the more savings there are the lower the interest rate; the less savings there are the higher the interest rate.

During the Bush years, many politicians villified the Chinese for currency manipulation. The Obama administration has called for China to float its currency and has begun leveling tariffs against Chinese imports. China has begun to retaliate with tariffs. Much of this may have been political theatrics due to the trade deficit initially but now it's slowly approaching trade war. The US transitioning from a manufacturing based economy to a services based economy is bunk.

Regulation vs Deregulation

In an effort to make housing affordable government has made housing less affordable; until recently home prices have been going up and up. The Community Reinvestment Act, designed to stop redlining of minority areas, was beefed up during the Clinton administration and under the Bush administration the government has enacted other programs to make housing affordable to those who can't afford it. Even now the Obama administration is offering $8,000 tax credits to try and make unaffordable housing affordable, in an effort to keep real estate prices inflated.

With Fannie and Freddie willing to take risk off the books to promote a property-owning America (an America that would pay more in property taxes coincidentally), mortgage originators, banks, and brokers had little to worry about. There was undoubtedly fraud and collusion between all parties involved, from consumers willing to lie about their income to originators who'd add projected property value increases as income to an applicant's paperwork. Secondary mortgages underwent a paradigm shift; once the hallmark of losers, they became a new way to extend credit to "yourself" for any reason whatsoever.

And Wall Street entered the frenzy with tranches of overrated collateralized mortgage obligations designed to mitigate risk by spreading it out. The higher the risk, the higher the yield but with diversification where losses should have always been small compared to gains they were seen to have little downside. They replicated the Fannie & Freddie model on the open market.

Real Estate TV shows became popular and either fed the speculative real estate frenzy or simply reflected it. Buyers became speculators to flip a house, live in it for five years and sell at a profit, etc... Rationality left the scene when risk departed.

As George Bush said, "Wall Street got drunk". What he didn't say is that the Federal Reserve supplied the booze through low interest rates held down by Chinese capital in Treasury Bonds to maintain a mutually-beneficial currency peg.

Housing Boom Gone Bust

As the housing boom roared on, eventually the amount of houses built exceeded the demand for houses. This glut of unsold homes reduced competition between homes which caused home prices to drop. Combined with ARMs resetting and the eventual failure of non-affordable "affordable" housing, the housing market crashed.

Mortgage defaults set the Wall Street tranches on fire. Lower home prices meant loan to value problems in banks. Freddie and Fannie's weak capitalization, thanks to government regulations and charter, was a disaster.

When government finally came to the rescue they sided with Wall Street over Main Street and billed the taxpayer (and their children and children's children) for the sum.

You make it seem like Freddie and Fannie were 100% responsible for the spread of sub-prime mortgages.

That is up for debate how much of a role they played:
Econbrowser: Did Fannie and Freddie cause the mortgage crisis?

If I were to throw blame around I'd blame the Federal Reserve for selling so many Treasuries. Their actions seem politically motivated to reinflate a bubble rather than to pursue sound economic activity to keep prices stable. F&F would be second on the list as they held somewhere near 55% of all mortgages in the US at the time and tabled risk. Their capital reserve requirements, as regulated by government, makes them inherently risky other than the taxpayer money-funnel they have access to.

As for Krugman and the Econbrowser, I don't agree. Their conclusion is Freddie and Fannie should have not only been bailed out but are even MORE central to the housing market. C'mon... really... that's rewarding failure in and of itself akin to advocating the Federal Reserve failure should be given more power because it failed.

Originally Posted by fafyrd

If I were to throw blame around I'd blame the Federal Reserve for selling so many Treasuries. Their actions seem politically motivated to reinflate a bubble rather than to pursue sound economic activity to keep prices stable. F&F would be second on the list as they held somewhere near 55% of all mortgages in the US at the time and tabled risk. Their capital reserve requirements, as regulated by government, makes them inherently risky other than the taxpayer money-funnel they have access to.

As for Krugman and the Econbrowser, I don't agree. Their conclusion is Freddie and Fannie should have not only been bailed out but are even MORE central to the housing market. C'mon... really... that's rewarding failure in and of itself akin to advocating the Federal Reserve failure should be given more power because it failed.

Where did you get the 55%?

My sources say 24%

The capital reserve requirements set a minimum amount of capital that banks MUST hold. It doesn't cap capital reserves, so there is no reason why banks could not have held more reserves and thus weathered the storm better.

Here in Australia, there is no required minimum of capital reserve, so the minimum is effectively 0%. Yet our banks rode the slump rather well.

And the article says nothing about what they conclude should happen to Freddie and Fannie. Unless I've missed something.

Originally Posted by Coffee Grinder

Where did you get the 55%?

My sources say 24%

The capital reserve requirements set a minimum amount of capital that banks MUST hold. It doesn't cap capital reserves, so there is no reason why banks could not have held more reserves and thus weathered the storm better.

Here in Australia, there is no required minimum of capital reserve, so the minimum is effectively 0%. Yet our banks rode the slump rather well.

And the article says nothing about what they conclude should happen to Freddie and Fannie. Unless I've missed something.

That reserve requirement is a key to leverage and therefore exposure to risk. I imagine the housing markets could have been very different in the US and Australia. Obviously the government sponsored regulations and incentives to homeownership would have been different. There are banks in the US that aren't part of the Federal Reserve System but I haven't read up on how they fared vs the Federal Reserve Banks. I'm not familiar with the Aussie banking system although I admire Aussie gold warehouses.

The blog agrees with and links to Krugman where he draws that conclusion. I suppose the Econbrowser disagrees with Krugman somewhat too. I guess, to me, it's kind of fuzzy whether or not Econbrowser agrees F&F should be given more power or are more central due to the failure. If I'm wrong on that bit it's just an assumption I made.

In the Econbrowser blog it shows 51% of mortgages were held or guaranteed by F&F in 2003. I plucked the 55% from memory, I'll see if I can dig something up though.

Fannie and Freddie had purchased $4.9 trillion of the mortgages outstanding as of the end of 2007, 70% of which the GSEs had packaged and sold to investors with a guarantee of payment, and the remainder of which Fannie and Freddie kept for their own portfolios. The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.