[GJM] Fw: [globalnetnews-summary] Debt capitalism self-destructs Page 4 of 4

[mary rose]

For your consideration.


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Subject: [globalnetnews-summary] Debt capitalism self-destructs Page 4 of 4



Jul 22, 2008


Debt capitalism self-destructs Page 4 of 4

By Henry C K Liu
http://www.atimes.com/atimes/Global_Economy/JG22Dj09.html

Treasury Secretary Henry Paulson said on Friday, July 6 this year that the 
government would support the GSEs "in their current form as they carry out 
their important mission". On Sunday, the Treasury issued a statement 
indicating that

    its main focus was still on supporting Fannie and Freddie in their 
current form. Fannie Mae and Freddie Mac play a central role in our housing 
finance system and must continue to do so in their current form as 
shareholder-owned companies. Their support for the housing market is 
particularly important as we work through the current housing correction. 
GSE debt is held by financial institutions around the world. Its continued 
strength is important to maintaining confidence and stability in our 
financial system and our financial markets. Therefore we must take steps to 
address the current situation as we move to a stronger regulatory structure.

Regulatory reform while necessary cannot be backdated. There are $5 trillion 
of outstanding debt instruments written under


problematic regulatory oversight that need to be dealt with. Expressions of 
support for the "current form" that has proved wanting by a wide margin, a 
new line of credit to support bad loans and a proposed unlimited injection 
of capital by government that would surely face congressional opposition is 
a prescription to muddle through a major structural rupture.

Government support
The ability of the GSEs to raise new capital and credit from private sources 
is totally dependent on government support. Thus the plan to support these 
GSEs in distress will be much more costly if it must be done through private 
profit incentives. The outcome is likely to be a new contraction in the 
supply, and increase in the cost, of mortgage finance - further lessening 
the chances of an early recovery in the housing market and the wider 
economy. Private profit incentive overwhelming public interest got the GSEs 
in trouble. How can more private profit incentives be expected to get them 
out of trouble?

The Fed has announced that it will allow Fannie Mae and Freddy Mac to borrow 
from its discount widow, normal open only to commercial banks and since 
March 2008 open also to investment banks as part of the bail out of Bear 
Stearns. Under a three-part proposal by the Treasury, the Fed will also be 
given a consultative role in setting capital requirements and other 
regulatory standards for Fannie and Freddie, as part of an evolution to be 
the top regulator and overseer of the nation's financial system.

Former Fed chairman Paul Volcker expressed concern that by expanding its 
role of lender of last resort to institutions beside commercial banks that 
previously were not allowed to hold positions in equities, the Fed may have 
opened itself up to moral hazard dangers if large institutions believe their 
adventurous behavior will be bailed out by the Fed.

With the Fed, whose perspective tends to align with those of its member 
banks, taking over many of the regulatory powers of the Security Exchange 
Commission, whose mandate was originally to protect the interest of small 
investors, the public interest may face further diminished protection.

Yet the financial market has irreversibly changed with the emergence of 
structured finance in which loan securitization has taken loans that once 
had to stay in the balance sheets of issuing banks but are now securitized 
and sold by brokers to institutional investors worldwide. Default of a major 
broker default, such as Fannie and Freddie, will be as damaging as failure 
of a major money-center bank and cause catastrophic collapse of the credit 
market.

In 1968, then president Lyndon Johnson, as part of his Great Society 
program, turned Fannie into a shareholder-owned company as part of a 
national housing policy to make finance capitalism finance the 
nationalization of housing. It was the beginning of corporate market 
socialism in the name of populist economic democracy. The public could only 
benefit if corporate and financial institutional interests could profit 
first. And the public must pay if market capitalism fails systemically, 
absolving the losses of wayward corporations and financial institutions.

In 1970, the savings and loan industry, envying the huge profit made by 
commercial and investment banks from Fannie Mae, called for and received 
congressional approval for a GSE of their own and Congress created Freddie 
Mac. Like the Urban Renewal program of the 1950s, the GSEs served a 
coalition of interest that included liberals who wanted to help low-income 
households, real state developers that wanted guaranteed demand, home 
builders that wanted a guaranteed market, local politicians who wanted tax 
revenue from redevelopment, banks that wanted lucrative risk-free loan 
proceeds and congressmen who wanted campaign contributions from mortgage 
lenders.

Too good to be true
Low-income voters were first dazzled by the new homes they were able to 
acquire with no money down and with monthly payments financed with home 
equity loans as house prices rose. They acted like Pinocchio in a Pleasure 
Island - that would soon turn them into jackasses to be sold to work in salt 
mines. The financial institutions were comforting their pangs of conscience 
over taking loans off their balance sheets as soon as they made them by 
excusing themselves with the idea that they were making low-cost mortgage 
available to millions of homebuyers. Neoliberal economists were celebrating 
the US miracle of mass capitalism that does not need capital.

The program of passing unsustainable loans to faceless investors benefited 
also land speculators, home builders, real estate agents, investment 
bankers, structured financiers and household furnishers. Since the main 
thrust of the GSE program was to help low- and moderate-income homebuyers, 
opposition was considered undemocratic.

Yet everyone knows that the GSEs face an interest-rate risk in their 
long-term mortgages if interest rates should rise over the loan period. To 
protect itself from interest rate risks, the GSEs use derivatives to hedge 
against interest-rate risk.

The OFHEO was created by the House Banking Committee chaired by Texas 
populist Henry Gonzalez in 1992 with minimal power to regulate the two giant 
GSEs on the ground that GSEs were institutions intended to support the 
national policy of a nation of homeowners by making housing loans affordable 
and should be exempt from regulation regulating commercial institutions.

The problem of this good policy intention was that during the era of 
neoliberal ascendancy, the light regulatory environment was used to negate a 
more fundamental economic law: the need to increase worker income to match 
mortgage payments, subsidized or not.

The GSEs have been financially successful because they combine private 
sector appetite for profit with access to government-backed credit at below 
market rates. It was a way to nationalize housing through the free market 
capitalism. The problem was that financial manipulation cannot replace the 
need for adequate income growth. The mismatch of income with asset price is 
the definition of a financial bubble. People were buying homes with cheap 
credit at prices that their income could not afford. The more home prices 
rose due to cheap credit, the more homeowners fell into the debt trap.

Yet in all the current talk about finding ways to deal with the crisis, not 
one single voice is heard from official circles about the need to increase 
worker income. Instead, false hopes on one-time stimulant tax rebates are 
hailed as the magic bullet.

Suddenly this summer, Fannie and Freddie's relatively anemic capital supply 
is a serious concern for the market. In one week in July, Fannie's stock 
plummeted to $10.25, down 74% in 2008. Freddie's shares also dived, closing 
at $7.75, a loss of 77% this year.

Even as investors stampede out of these battered stocks, the sycophants of 
free market capitalism in Washington, led by Treasury Secretary Paulson and 
Federal Reserve chairman Ben Bernanke, rushed to reassure the market, 
pointing out that the mortgage giants' regulators had confirmed that the 
companies were "adequately capitalized", trying to give the impression that 
regulators had the problem firmly in hand and that no new capital was needed 
by the GSEs.

But these two leaders had lost much credibility since in August 2007 when 
they voiced a similar mantra that problems in the mortgage market were 
"contained" to subprime loans and would not spread beyond. SEC chairman 
Christopher Cox tried to calm investors by telling them that Bear Stearns 
passed financial muster only days before it required a Fed-engineered bail 
out by JP Morgan Chase with Fed loans.

More than capital adequacy is at risk. The credibility of the team with 
responsibility for the nation's monetary system and its financial market is 
heading for a meltdown. Unfortunately, credibility is much easier to lose 
than to regain. (See America's Untested Management Team Asia Times Online, 
June 17, 2006.)

Recurring anxiety
Anxiety about Fannie and Freddie's liabilities of more than $5 trillion 
getting too big for the funding authority of the Federal Reserve of a measly 
$2.5 billion credit line has been a recurring concern in many quarters in 
recent years. Even after both GSEs were found to be infested with accounting 
irregularities (Freddie Mac in 2003 and Fannie Mae in 2004), Congress failed 
to act, except to make the regulator require the GSEs to hold 30% more 
capital than the minimum previously required, in effect capping their 
ability to purchase mortgages when the housing bubble was approach its peak.

Still, Fannie and Freddie were allowed to pose as high-growth companies 
whose shares were safe enough for widows and orphans. GSE market share fell 
to 45% at the peak of the housing bubble. After the bubble burst, it rose to 
68% in the first quarter of 2008.

After empty official assurances failed to convince the market because it was 
plain for all to see that the two GSEs' direct and guaranteed liabilities 
were almost 65 times their regulatory capital at the end of the first 
quarter of 2008, the near-term priority was to restore the rapidly fading 
confidence of buyers of Fannie's and Freddie's debt, many of whom are 
foreigners. By increasing the GSEs' credit line and pushing for authority to 
inject fresh equity if necessary, the Treasury's proposed plan appears to be 
aimed at allaying fears of widespread counterparty default and market 
failure. Freddie seemed to have no serious problem offloading $3 billion of 
new paper on Monday, July 14, although arm-twisting was rumored to have been 
needed to persuade banks to buy it.

The bigger problem for Washington is that merely stabilizing Fannie and 
Freddie is not enough. With US banks seriously distressed by the credit 
crisis, the GSEs, which hold or guarantee 22% of the $24.3 trillion 
outstanding debts borrowed by US households and the non-financial sector, 
are a major source of credit. Yet the market is clearly uncomfortable with 
the inability of the GSEs to maintain its over-bloated balance sheet. The 
options are either to shrink the balance sheet drastically, thus 
exacerbating the credit crisis, or to seek a massive injection of new 
capital, both requiring government action at an unprecedented scale.

Despite these ad hoc measures, which may or may not receive congressional 
approval, the whole world knows that credit capacity is shrinking 
drastically in the market. There are rumors that the US is pressing foreign 
central banks to acquire more GSE debt, but the market is inundated with 
fear of new crises before the housing market recovers. And the housing 
market is lying in a coma in intensive care with an oxygen tank of new 
credit running near empty.

As the housing market collapses, both GSE companies are reporting steep 
losses. But the subprime mortgage meltdown has also made the GSEs more 
important than ever in holding up the housing finance sector. Since the 
credit markets seized up, Fannie and Freddie have regained their central 
role in mortgage finance after losing significant market share to investment 
banks during the housing boom. They have issued the vast majority of 
mortgage securities sold in the last six months because investors have lost 
confidence in deals put together by big investment banks.

In February 2008, prodded by the Treasury, federal regulators announced they 
were easing some restrictions on lending by Fannie and Freddie. Then on 
March 19 the federal government announced that it was easing those 
restrictions in an effort to calm the turmoil afflicting the mortgage 
markets. Officials said the change could allow the two GSEs to invest $200 
billion more in mortgages.

Alarmed by the sharply eroding market confidence in the nation's two GSEs, 
the largest mortgage finance companies, the Bush administration announced 
plans on Sunday, July 13 to ask Congress to approve a sweeping rescue 
package that would give officials the power to inject unlimited funds into 
the beleaguered companies through investments and loans.

In a separate announcement, the Federal Reserve said that at the request of 
the Treasury it would make one of its temporary short-term lending programs 
at the discount window available to the two GSEs, "to promote the 
availability of home mortgage credit during a period of stress in financial 
markets." The program for the GSEs would end when Congress approves the 
Treasury's proposed plan.

Treasury Secretary Paulson announced dramatically Sunday on the steps of the 
Treasury building: "The president has asked me to work with Congress to act 
on this plan immediately. Fannie Mae and Freddie Mac play a central role in 
our housing finance system and must continue to do so in their current form 
as shareholder-owned companies. Their support for the housing market is 
particularly important as we work through the current housing correction."

Paulson paradox
While officials in successive administrations, both Republican and Democrat, 
have for many years repeatedly denied that the trillions of dollars of debt 
Fannie and Freddie issued is guaranteed by the government, the Paulson 
package, if adopted, would bring the Treasury closer than ever to exposing 
taxpayers to potentially huge new liabilities. The two GSEs are expected to 
face significant new losses this year as the wave of housing foreclosures 
continues and rises. Paulson seemed to suggest that there is no choice but 
for the government to intervene. The proposed plan, requiring the Treasury 
to be giving authority by Congress to command unlimited funds to stabilize 
the GSEs, is predicated on the hope that the very availability of unlimited 
funds would make it unnecessary to use them. The investment and lending 
elements of the proposed plan are to last two years.

Over the weekend, Treasury officials sought assurances from Wall Street 
firms that the $3 billion auction on Monday by Freddie Mac of short-term 
debt would go off without a hitch. While $3 billion is a relatively small 
sum for an institution of Freddie's size, officials said they did not want 
to risk even a small misstep that could set off a new round of problems. 
Despite repeated assurances by top officials that the companies had adequate 
cash to weather the current financial storm, Fannie and Freddie had suffered 
a withering blow of confidence the week before. As a result, Freddie was 
faced with an uncertain debt offering on Monday. Should Fannie and Freddie 
fail, $5.3 trillion in mortgage debt would go unpaid. As it happened, the 
offering went smoothly but everyone knew it was not a normal market.

Freddie Mac continued to try to raise capital from private investors even 
after a government rescue plan it and its sister company Fannie Mae was 
announced the weekend before, indicating concern that the government plan 
may be delayed in Congress. On Friday, July 18, Freddie Mac cleared one of 
the last obstacles to raising new capital through a planned $5.5 billion 
stock offering when it received approval to register with US securities 
regulators. However, Freddie Mac's ability to attract much-needed capital 
from new and existing shareholders has been potentially lessened by the 
possibility of a future government stake that might place restrictions on 
the business. There is also little clarity with regard to where in the 
capital structure the government might invest, and how dilutive such a move 
would be to existing shareholders.

The government's rescue plan, which would allow the Treasury unlimited 
powers until the end of 2009 to increase its credit line to Fannie Mae and 
Freddie Mac and invest in their equity, met some strong vocal resistance in 
Congressional hearings during the week before July 18.

While many expect Congress to have no option except to approve the Paulson 
plan, a few skeptics were voicing their opposition in public hearings. 
Senator Jim Bunning, a Republican from Kentucky, described Paulson as 
"asking for a blank check ... for this unprecedented intervention in our 
free markets." He also vowed to try his best to stop a proposal that would 
give the Federal Reserve sweeping new powers aimed at protecting the 
nation's shaky financial system. Bunning said the Federal Reserve "can't be 
trusted with the power it already has". He says the Fed's policies in recent 
years have contributed to economic woes, including surging inflation, a 
declining dollar and the housing bust.

"When I picked up my newspaper yesterday, I thought I woke up in France. But 
no, it turns out socialism is alive and well in America. The Treasury 
Secretary is asking for a blank check to buy as much Fannie and Freddie debt 
or equity as he wants. The Fed's purchase of Bear Stearns' assets was 
amateur socialism compared to this," thundered the Republican Senator 
against his own party's Treasury secretary. In US political discourse, 
socialism is a dirty word, albeit what Paulson proposes is not anywhere near 
what socialism is commonly understood to be in the rest of the world, but a 
scheme to use public funds to save debt capitalism by frustrating the right 
to fail in market capitalism.

Predatory lending
Ron Paul, Republican congressman from Texas, told Bernanke that the Federal 
Reserve is a "predatory lender". But he did not mention that by law, 
predatory lenders forfeit any right of collection.

Lender liability is embodied in common and statutory law covering a broad 
spectrum of claims surrounding predatory lending. It is a key concept in 
environmental-cleanup litigation. If a lender knowingly lends to a borrower 
who is obviously unable to make reasonable beneficial gain from the use of 
the funds, or causes the borrower to assume responsibilities that are 
obviously beyond the borrower's capacity, the lender not only risks losing 
the loan without recourse but is also liable for the financial damage to the 
borrower caused by such loans. For example, if a bank lends to a trust 
client who is a minor, or someone who had no business experience, to start a 
risky business that resulted in the loss not only of the loan but of the 
client trust account, the bank may well be required by the court to make 
whole the client.

In the United States, although predatory lending is not defined by federal 
law, and various states define abusive lending differently, it usually 
involves practices that strip equity away from a homeowner, or equity from a 
company, or condemn the debtor into perpetual indenture. Predatory or 
abusive lending practices can include making a loan to a borrower without 
regard to the borrower's ability to repay, repeatedly refinancing a loan 
within a short period of time and charging high points and fees with each 
refinance, charging excessive rates and fees to a borrower who qualifies for 
lower rates and/or fees offered by the lender, or imposing new unjustifiably 
harsh terms for rolling over existing debt. Predation breaks the links 
between an economy's aggregate resource endowment and aggregate consumption 
and between the interpersonal distribution of endowments and the 
interpersonal distribution of consumption.

The choice by some to be predators decreases aggregate consumption, both 
because the predators' resources are wasted and because producers sacrifice 
production by allocating resources to guarding against predators. Much of 
welfare economics is based on the concept of pareto optimum, which asserts 
that resources are optimally distributed when an individual cannot move into 
a better position without putting someone else into a worse position. In an 
unjust global society, the pareto optimum will perpetuate injustice.

Now, there is a close parallel in most Third World debts and International 
Monetary Fund (IMF) rescue packages to the above predation examples, where 
sophisticated international bankers knowingly lend to dubious schemes in 
developing economies merely to get their fees and high interest, knowing 
that "countries don't go bankrupt", as Walter Wriston, former chairman of 
Citibank, once famously proclaimed.

The argument for Third World debt forgiveness contains large measures of 
lender liability and predatory lending. Debt securitization allows predatory 
bankers to pass the risk to global credit markets, socializing the potential 
damage after skimming off the privatized profits. The housing bubble has 
been created largely by predatory lending without any lender liability. The 
argument for forgiving Third World debt is applicable to low- and 
moderate-income home mortgage borrowers in the US as well. Let's hear some 
proactive commitments from the presumptive candidates of both political 
parties instead of empty populist campaign rhetoric.

Henry C K Liu is chairman of a New York-based private investment group. His 
website is at http://www.henryckliu.com.