Fannie, Freddie and the five trillion dollar screw-up
Stand by. The US Treasury is about to take over Fannie Mae and Freddy Mac, the two giant mortgage underwriting companies that underpin the entire US property market. We knew they had the power to do this since 23 July, when legislation was passed allowing Hank Paulson to do this (see this timeline for a study in market self-delusion).
[Update: it has just been announced.]
But the plan was they would not need to do it: the "facility" itself would stave off the need to use it (a bit like the theory of dreadnoughts before World War One). Indeed Fannie and Freddie have been issuing new debt and, at one point, their shares even rebounded. So this was not in the script. The 20% share price slide that took place after hours on Friday was a response to new information that their balance sheets - the ratio of capital to the debts they are owed - were weaker than expected. Fanny and Freddie are finished in their current, half-life form.
The size of the event is so massive that I think we are already seeing the same kind of denial behaviour that accompanied the war in Georgia; Then it was, "Hey the whole post-1989 world order has collapsed! But wow, look at that Olympic opening ceremony!" Now it's Obama and McCain "welcoming" the move, statesmanlike, before moving on to the issue of earmarks, porkbarrels etc as they tour the swing states. The two companies will be taken into "conservatorship" - a kind of economic equivalent of "arguido status"....
...But let us be clear what this is: it is a state backed bailout of the financial system on a massive scale. The US national debt is $5 trillion; Fannie and Freddie's combined liabilities are $5.3 trillion. Congress increased the legal ceiling on the national debt to $10.7 trillion in July in anticipation of this bailout, which should just about cover it.
In one sense, all that has happened here is the recognition of the de facto government guarantee on Fannie and Freddie mortgages. And the short-term outcome could be benign: some commentators argue that, once it's backed by the taxpayer, the Fannie and Freddie loan book should charge lower interest rates, bringing mortgage rates down for about 2/3 of US home owners. And the takeover will prevent the unthinkable - which is the injection of 5 trillion worth of bad debt into the world economy.
But there will be losers: foremost the shareholders, whose capital will be worthless. It remains to be seen what happens to debt-holding financial institutions.
The reaction of the presidential contenders is clear and divergent: both camps will back the bailout. Obama wants the two mortgage giants turned into non-profit companies, but the management sacked. Meanwhile...
"Senator McCain will get real regulation that limits their ability to borrow, shrinks their size until they are no longer a threat to our economy, and privatizes and eliminates their links to the government," Doug Holtz-Eakin, a senior McCain policy adviser told US journalists.
Of the two strategies, Obama's will be the more easily done - and for the same reason Gordon Brown is looking at mortgage policy briefing papers with the figure 40 followed by a lot of noughts right now. Without Fannie & Freddie, who is going to underwrite mortgages in the USA? Shrink them, privatise them or abolish them, you must first put in place a source of mortgage finance that is as cheap and effective as a semi-state backed finance corp or see either the cost of mortgages rise, or their supply plummet.
But of course Obama's suggested course is full of pitfalls too: the whole "magic" of Fannie and Freddie since the late 1960s has been their ability to evade categorisation of the debt: it looked private, as we now know it was really public. There is a good argument for a state backed mortgage guarantee system when nobody else is prepared to issue the guarantee. But you can't pretend this is free-market capitalism. It is the institution which is at fault, not the management
Inter alia, Saul Alinsky's Rules for Radicals advises: "Don't try to attack abstract corporations or bureaucracies. Identify a responsible individual. Ignore attempts to shift or spread the blame." - and Obama's targeting of the management as self-seeking is a textbook application of these rules.
The fact remains that, come tonight, America's effective national debt will have doubled. And at one level it is only theoretical but that's what accounting rules exist to do: calculate the financial impact of what is theoretically possible.
I come back to one of Idle Scrawl's recurrent themes: what you have in the USA, and quite possibly at some point here, is a state-backed bailout of the financial system whose whole social purpose has been sold to us as the risk-taking self-reliant dynamo of wealth creation and excellence. An industry that has been deregulated notch by notch over the past 20 years on the grounds that it shoulders all the risks and should garner the rewards, turns out to be shouldering very few of the risks: only the shareholders get burned. The debt holders always get bailed out. So it was with Northern Rock, so it is with F&F.
At least with subprime and credit default swaps it was complicated: so complicated that even the CEOs of major banks did not understand what thier trading strategy whizz kids were doing. But this was simple. I hope somebody is going through the public statements of both the US Treasury and the F&F managements to compare them with what we now know to be true: these institutions are on the brink of insolvency.
We are left with a massive mismatch between theory and practice, calling not just for reactive measures but a level of honesty from the world's politicians about what kind of regulatory system they are going to put in place to stop this happening again. All across the globe politicians are being forced to act in a way they never thought would happen; and the commentariat understands so little that it simply rattles on with the old orthodoxies as if nothing's happened. Read the British Sunday business supplements to see what I mean.
But no matter, the Arizona Cardinals are playing the 49ers live on American TV tonight; and it's the Chicago Bears verus the Colts too; and, hey, Palin's glasses look cool, no?