January 26, 2010
As our friend David Kotok noted, the Treasury’s action moves us one step closer to the day when the government will formally nationalize Fannie and Freddie and add their debt to the nation’s already swollen balance sheet. But the difference between the so-called “implied” guarantee and a formal guarantee at this point is a matter of form over substance – nobody believes that the U.S. government will ever walk away from these obligations. For all intents and purposes, these companies were nationalized long ago and the financial crisis just confirmed what everybody already believed. Accordingly, the latest move, designed to minimize press coverage and market disruption, fooled absolutely nobody but showed the limitations of our leaders. The U.S national debt is not $11 trillion, but $16.5 trillion and rising once Fannie and Freddie are counted.
Mr. Kotok also makes the very important point that this move adds to the necessity for the Federal Reserve to maintain low interest rates for a prolonged period of time. In 2009, the Federal Reserve bought more than $1.1 trillion of Fannie’s and Freddie’s home-loan bonds and more than $124 billion of their corporate debt in an effort to lower their funding costs. This helped push mortgage rates to a record low of 4.71 percent in December 2009. Throughout 2009, rates on a typical fixed-rate 30-year mortgage averaged 5.04 percent, down from 6.05 percent in 2008, according to weekly surveys from Freddie Mac. Mortgage rates need to stay as low as possible for the housing market to have any chance of recovery. Rates on Fannie and Freddie paper will play an important role in determining where mortgage rates settle out in 2010. The Federal Reserve will be sure to do everything in its power to keep mortgage rates low, which means that zero interest rates are here to stay for the foreseeable future.
But the rot runs even deeper at Fannie and Freddie. The government had to do even more to keep the two GSEs afloat. In order to keep Fannie and Freddie solvent, the Treasury had to purchase $191 billion of their mortgage bonds and $112 billion of their preferred stock. Why did the Treasury have to do this? Because the companies lost a combined $188.4 billion over the last nine quarters! That is even greater more money than AIG lost during this period. This is the performance for which their CEOs – who are working for the government - are being paid millions of dollars!!!!!?????
The Treasury Department’s management of the GSEs continues the disastrous Congressional creation and management of these entities. Trying to slip through the extension of aid on Christmas Eve was also amateurish at best. There was absolutely no chance that savvy market watchers would fail to factor the lifting of limits on aid to the two housing agencies into their investment and trading calculations. Moreover, the Treasury Department must be seen to be engaging in more of the same wrongheaded economic policies that caused the financial crisis in the first place, and delaying the necessary adjustments that need to occur in order to purge the economy of the excesses that are preventing it from regaining a productive growth path. To quote Marc Faber: “the ‘crisis’ is unlikely to compel economists at the Fed and the Treasury ‘to reach for a new paradigm.’ With fiscal and monetary measures they will attempt to prevent consumer prices from declining, which would actually be favorable for the economy as consumers’ purchasing power would increase…But in the process of combating consumer price declines, these economists and bureaucrats will create massive bubbles in one or another sector of the global economy, which will lead to renewed economic and financial instability sometime in the future.”3 Actually, rather than creating a new housing bubble moves like the Treasury’s are preventing the previous bubble from being effectively unwound.
Between the end of 2002 and the end of 2006, total U.S. outstanding debt increased from $31.84 trillion to $45.32 trillion, an increase of 42.3 percent. By 2006, total U.S. indebtedness equated to 350 percent of GDP.4 This rise in indebtedness coincided with a period of extremely low interest rates and brought the country to the cusp of the financial crisis. Moreover, a significant portion of this indebtedness was concentrated in the financial sector. Between the end of 2002 and the end of 2007, financial sector debt increased from $10.1 trillion to $16 trillion, reaching an unprecedented 117 percent of U.S. GDP.5 We all know what happened then (we were treated to a front row seat to Hyman Minsky’s “financial-instability hypothesis”), and what the authorities did to combat the near collapse of the system – they increased debt further to replace the trillions of debt that was wiped out. Virtually everybody considered this traditional Keynesian approach to the crisis to be the correct one because the alternative – a complete systemic collapse – was considered unthinkable. But treating a debt crisis with more debt can only delay the ultimate day of reckoning, which is one reason why assets such as gold are rising while paper assets such as the U.S. dollar and other fiat currencies are falling. The hope is that delaying the end of days will give policymakers time to design a different and far less painful endgame. In order to do that, however, they are going to have to start heeding the lessons of the past. And there is little indication that they will be able to that. But this is the beginning of a new year, so one can always hope. But while one hopes, one should also be preparing for the worst.
Bernanke the clueless
We will definitely need to prepare for the worst as long as our leaders continue to deny the obvious. In a speech on January 3, Federal Reserve Chairman Ben Bernanke argued that low interest rates did not cause the housing bubble. Instead, he argued that monetary policy after 2001 “appears to have been reasonably appropriate, at least in relation to” the so-called Taylor Rule. The Taylor Rule is named after Stanford University economist and former Treasury undersecretary John Taylor, who created a shorthand formula that outlined how a central bank should set rates if inflation or growth veers from targets. This is another example of why economic policy should not be left in the hands of professors who have little real-world experience. For Mr. Bernanke to continue to argue at this point in time, when the evidence is staring him in the face, that low rates did not cause the housing bubble is truly alarming. It frankly should be sufficient to disqualify him from serving another term as Chairman of our central bank because it suggests that he has no understanding of how the real economy works (a flaw he shares with his predecessor, Alan Greenspan). But his comments also make it clear that as long as Mr. Bernanke is in charge, the Federal Reserve will keep rates low for a very, very long time because he doesn’t believe that low rates cause bubbles.
3 Marc Faber, The Gloom, Boom & Doom Report, December 2009, p. 6.
4 See John Cassidy, How Markets Fail: The Logic of Economic Calamities (New York: Farrar, Straus and Giroux, 2009), p. 223. I highly recommend this book to serious students of the market.
5 Ibid., p. 225.
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