July 16, 2008


The next big wave is breaking
By F William Engdahl

The announcement by US Treasury secretary Henry Paulson, together with Federal Reserve chairman Ben Bernanke, that the US government will bail out the two largest guarantors of the country's housing mortgage debt - Fannie Mae and Freddie Mac - far from calming financial markets has confirmed what we have said repeatedly in this space: the financial tsunami that began in August 2007 in the relatively small "subprime" high-risk mortgage securitization market, far from being over, is only gathering momentum.

As with the tsunami that devastated Asia in wave after terrifying wave in December 2004, what we are witnessing now is a low-amplitude, long-wave phenomenon of trillions of dollars of financial securities being unwound, defaulted on, and dumped on the market.

The scale of the latest wave to hit, the collapse of confidence in the two government-sponsored entities, Freddie Mac and Fannie Mae, is a harbinger of worse to come in what will be the most devastating financial and economic catastrophe in United States history. The impact will be felt globally.

The Royal Bank of Scotland (RBS), one of the largest financial institutions in the European Union, has warned its clients that "a very nasty period is soon to be upon us - be prepared". RBS expects the S&P-500 index of US stocks, one of the broadest stock indices in Wall Street used by hedge funds, banks and pension funds, could lose almost 23% by September as, in the bank's phrase, "all the chickens come home to roost" from the excesses of the US-led securitization revolution that took hold after the dot.com bubble burst and then Fed chairman Alan Greenspan lowered US interest rates to levels not sustained since the 1930's Great Depression.

This will be seen in history as the disastrous Greenspan "Revolution in Finance" - an experiment in asset-backed securitization, a mad attempt to bundle risk into loans, "securitize" them in new bonds, insure them via specialized insurers called "monoline" insurers (which insured only financial risks in bonds), then rate them via Moody's and Standard & Poor's as AAA, or highest grade. All that was done so that pension funds and banks around the world would assume they were high-quality debt.

Fed in panic mode
While he is getting praise in the financial media for his "innovative" and quick reactions to the unraveling crisis, Fed chairman Bernanke in reality is in a panic mode. His room to act is increasingly bound by the soaring asset price inflation in food and oil, which is pushing consumer price inflation to new highs even by the doctored "core inflation" model of the Fed.

If Bernanke continues to provide unlimited liquidity to prevent a banking system collapse, he risks destroying the US corporate and Treasury bond market and with it the dollar. If Bernanke acts to save the heart of the US capital market - its bond market - by raising interest rates, the Fed's only anti-inflation weapon, it will only trigger the next even more devastating round in tsunami shock waves.

The US government passed the law creating Fannie Mae in 1938 during the Great Depression as part of president Franklin D Roosevelt's New Deal. It was intended to be a private entity, although "government sponsored", that would enable Americans to finance buying of homes as part of the country's attempt at economic recovery. Freddie Mac was formed by Congress in 1970, to help revive the home-loan market. Congress started the companies to promote home buying and their charters give the Treasury the authority to extend a US$2.25 billion credit line.

The problem with the privately owned government-sponsored entities, or GSEs, as they are technically known, is that Congress tried to fudge on whether they were subject to government guarantee in the event of a financial crisis such as the present one. Before now, that appeared a manageable problem. No more.

The United States economy is in the early phase of its worst housing-price collapse since the 1930s. No end is in sight. Fannie Mae and Freddie Mac, as private stock companies, have gone to excesses in leveraging their risk, much as many private banks did. The financial market bought the bonds of Fannie Mae and Freddie Mac because they bet that the two were "too big to fail," that is, in a crisis the government - more accurately the US taxpayer - would be forced to step in and bail them out.

The two companies either own or guarantee about half of the $12 trillion in outstanding US home mortgage loans, or $6 trillion - which is also about half the combined gross domestic product (GDP) of the entire 27 member states of the European Union in 2006, or almost three times Germany's GDP that year.

In addition to their home mortgage loans, Fannie Mae has $831 billion in outstanding corporate bonds and Freddie Mac $644 billion.

Freddie Mac owes $5.2 billion more than its assets today are worth, meaning under current US "fair value" accounting rules, it is insolvent. Fair value of Fannie Mae assets has dropped 66% to $12 billion and may go negative next quarter. As home prices continue to fall across America, and corporate bankruptcies spread, the size of the negative values of the two will explode.

On July 14, Treasury secretary Paulson, former chairman of Wall Street investment bank Goldman Sachs, stood on the steps of the Treasury building in Washington, in a clear attempt to add gravitas to the occasion, and announced that the George W Bush administration would submit a bill proposal to Congress to make taxpayer guarantee of Freddie Mac and Fannie Mae explicit. In effect, in the present crisis it will mean nationalization of the $6 trillion agencies.

The bailout statement by Paulson was accompanied by an announcement by Bernanke that the Fed stood ready to pump unlimited liquidity into the two companies.

The Federal Reserve is rapidly becoming the world's largest financial garbage dump, as for months it has agreed to accept banks' asset-backed securities, including sub-prime real estate bonds, as collateral in return for US Treasury bond purchases. Now it agrees to add to that potentially $6 trillion in GSE real estate debt.

Yet the disaster in the two private companies was obvious as far back as 2003 when grave accounting abuses were made public. In 2003, William Poole, then president of the St Louis Federal Reserve, publicly called for the government to cut its implied guarantee of Freddie Mac and Fannie Mae, claiming then that the two lacked capital to weather a severe financial crisis. Poole, whose warnings were dismissed by then Fed chairman Greenspan, called repeatedly in 2006 and again in 2007 for Congress to repeal their charters and avoid the predictable taxpayer cost of a huge bailout.

Meanwhile some investors are viewing the Paulson bailout not as a bid to rescue the US economy but a lifeline for his former Wall Street cronies as the country's big banks teeter towards a financial implosion. What until recently had been the largest bank in terms of loans outstanding, Citigroup in New York, has been forced to raise billions in capital from sovereign wealth funds in Saudi Arabia and elsewhere to remain in business.

In a statement in May, Citigroup's new chairman, Vikram Pandit, announced plans to reduce the bank's $2.2 billion balance sheet of liabilities. However, he never mentioned an added $1.1 trillion in Citigroup "off balance sheet" liabilities, which include some of the highest risk deals in the US real estate and securitization era it so strongly backed.

The Financial Accounting Standards Board in Connecticut, the official body defining bank accounting rules is demanding tighter disclosure standards. Analysts fear Citigroup could face devastating new losses as a result, with the value of liabilities exceeding the bank’s $90 billion market value. In December 2006, prior to the onset of this financial crisis, Citigroup had a market value of more than $270 billion.

F William Engdahl is the author of A Century of War: Anglo-American Oil Politics and the New World Order, Pluto Press Ltd. Further articles can be found at his website, www.engdahl.oilgeopolitics.net.

(Copyright 2008 F William Engdahl.)

No comments: