Bailing out the Bubble's Enablers

Michael Hudson

[Michael Hudson is Chief Economic Advisor to Dennis Kucinich and the Kucinich-for-Congress campaign. A former Wall Street financial analyst, he is Distinguished Research Professor of Economics at UMKC, and author of
Super Imperialism: The Economic Strategy of American Empire
(new ed. Pluto 2002), and Debt and Economic Renewal in the Ancient Near East (CDL Press, 2002). This article was written during 2002]

When millions of homeowners see the price of their homes falling below the mortgages they owe, there are two possible responses. The first is to re-set bad debts at levels that owners can pay. This write-down is in keeping with the direction of legislation since the 13th century favoring debtors more than creditors. It would restore balance between what people earn and what they can afford to pay for housing.

This is not the path that Congress is taking. Instead of bringing debts within the ability to pay, its banking and real estate committees are seeking to re-inflate housing prices. The hope is to enable existing debtors on the brink of default to get their mortgage lenders off the hook by selling out or borrowing on even easier terms from the Federal Housing Administration (FHA), leaving it rather than Wall Street holding packages of junk mortgages. This would bail out financial institutions stuck with some of the $5 trillion in mortgages guaranteed by the Federal National Mortgage Association (FNMA, or Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), as well as the monoline default-insurance companies on the hook and whose IOUs have now sunk to junk status themselves.

The Democratic congress pushes for American families to pay higher home prices

These are the major campaign contributors and lobbying powers to whom Congressional banking committee heads are giving priority. Led by Democratic senators Charles Schumer from Wall Street and Christopher Dodd from Connecticut's insurance industry, and supported by Congressman Barney Frank, Congress is seeking to bail out the bubble's sponsors, not its victims. Their plan is to re-inflate the housing bubble to keep it growing at least long enough for the largest banks and other financial speculators to dump their riskiest holdings, whose book value is purely fictitious, although given the usual AAA whitewash from the leading bond-rating agencies, which themselves are now under investigation for a fatal conflict of interest between the research and sales arms, Arthur Anderson-style.

Dealing as they do with real estate, and hence with local urban politics where most of the property values and maneuvering occur, Fannie Mae and Freddie Mac are largely Democratic creations. James A. Johnson ran Fannie for most of the 1990s and was its main lobbyist. Until June he headed Barack Obama's vice-presidential search team, but resigned when it was revealed that he got mortgages on unrealistically favorable terms from Angelo Mozilo's notorious Countrywide Financial. FNMA's former head, Franklin D. Raines, was President Clinton's budget chief. He was forced to step down when serious accounting problems were discovered. Other Fannie apparatchicks include Jamie Gorelick, former Clinton deputy attorney general, and Thomas E. Donilon, Clinton chief of staff to the secretary of state.

To be sure, political opportunism leads Fannie and Freddie to cover all the bases, becoming known for hiring relatives of powerful politicians wherever they may be in a position to help. But at least this time the problem is not George Bush's fault. The Wall Street Journal seems closer to reason than the Democratic Congress. Over the weekend its editorial clarified what socialists since Marx have been saying: "What taxpayers need to understand is that Fannie and Freddie already practice socialism, albeit of the dishonest kind. Their profit is privatized but their risk is socialized." Calling FNMA and Freddie "high-risk monsters," the newspaper noted that "Wall Street and the homebuilders also cashed in on the subsidized business, and also paid back Congress in cash and carry." It concluded by questioning whether these government-sponsored enterprises (GSEs) were justified at all. "Apart from outright failure, the worst scenario would be a capital injection that left the companies free to commit the same mayhem all over again two or 10 years from now."

In a separate article the Journal noted that, "On a fair-value basis, the company [Freddie Mac] had negative net worth of nearly $17 billion." The problem is that there is no "market" -- that is, no supply of equally gullible buyers -- to take on these bad loans, except at distress prices. Through short-term greed and incompetence, the home-debt industry has pawned off highly debt-leveraged mortgage loans drawn up from fraudsters. I cannot actually call them crooks because instead of being indicted, they have been rewarded with tens of millions of dollars in bonuses for making so much money for the finance, insurance and real estate sectors as debt innovators.

Their place is to be taken by the government as bad-debt buyer of last resort. I suppose this might be called Finance Socialism -- the stage at which it becomes necessary to rescue Finance Capitalism, at least its largest institutions ("too large to fail") at the top of the economic pyramid. I suppose it might be called "real estate finance capitalism." But in Washington-talk it is euphemized in the Democratic Party's usual populist garb as "democratizing property" and "increasing homeownership," by which is meant indebting a rising share of the population to the point where carrying their mortgage absorbs most of their disposable personal income.

Can a new real estate bubble be inflated?

The fact remains that like every financial bubble in history starting with England's South Sea Bubble and France's Mississippi Bubble in the 1710s nearly three centuries ago, today's bubble has been sponsored by the government. Forget the "madness of crowds" free-market propaganda. Insiders and enabling politicians always try to blame the victim. The reality is that Fannie, Freddie and the FHA gave a patina of confidence to irresponsible lending and outright fraud. This confidence game led them to guarantee some $5.3 trillion of mortgages, and to keep $1.6 trillion more on their own books to back the bonds they issued to institutional investors. Their strategy has been to issue bonds paying fairly low interest rates, and use the proceeds to buy mortgages yielding somewhat higher rates. This kind of interest-rate arbitrage is what the S&Ls did in the 1980s - a relevant parallel, as I will discuss below.

The myth is that Fannie's and Freddie's role is simply to spread homeownership by making it affordable for more of the population. Fannie Mae was established in the Depression, in 1938 as part of Roosevelt's New Deal, and privatized in 1968. Freddie Mac was established two years later, in 1970, to buy up S&L mortgages and give "liquidity" to their mortgages, by developing markets outside of the banks and S&Ls that originated these loans. But this turned out to be the "original sin," so to speak. Outside investors were obliged to place their trust in the mortgage originators - banks, S&Ls and mortgage brokers, whose ranks are filled with fraudsters and crooks.

Whatever we may call it, their dream is to bring back the seeming golden age sponsored by Alan Greenspan at the Federal Reserve. It was a decade of quick mortgage billionaires writing fictitiously high mortgages and selling them off to pension funds and to German and English bankers eager to seek a few extra fractions of a percentage point in current income so as to justify a big bonus by claiming to outperform more reality-based money managers.

All this is as American as apple pie. Altruistic political talk aside, the reason why the finance, insurance and real estate (FIRE) sectors have lobbied so hard for Fannie and Freddie is that their financial function has been to make housing increasingly unaffordable. They have inflated asset prices with credit that has indebted homeowners to a degree unprecedented in history. This is why the real estate bubble has burst, after all. Yet Congress now acts as if the only way to resolve the debt problem is to create yet more debt, to inflate real estate prices all the more by arranging yet more credit to bid up the prices that homebuyers must pay. The plan is thus to pretend that the Bubble Economy's financial unreality may be made real by Finance Socialism.

Can the plan work? The reason why Fannie and Freddie have been able to borrow at lower rates than their rivals is because their public sponsorship led investors to believe that there was an implicit public guarantee not to let them fail. And in view of the fact that these two agencies account for some $5 trillion in mortgages - nearly half the nearly $12 trillion U.S. home mortgage market - they do indeed seem to be "too big to fail." The face value of mortgages they have guaranteed is nearly as large as the entire U.S. federal debt held by the public. This means that the nominal federal debt would double if they went under. But at least the government can always print money, while the real estate backing the mortgages guaranteed by Fannie and Freddie (or held in their own accounts) is plunging in price into the dreaded Negative Equity territory.

But on their shoulders ride the hope of re-inflating housing prices to bail out the financial managers who sought to make money by debt creation rather than tangible capital formation. So the question is whether housing prices can be raised to a level that oblige families to run into even more debt than they now are carrying - with even lower down payments, subsidized at public expense.

In this case the subsidy would not really be for homeowners at all, but for the financial system's mortgage holders. The aim would not be to make housing more affordable, but less so!

Most investors view the situation as being more political than strictly economic. One hears again and again these days about the "implicit" government guarantee to make good on the bonds Fannie and Fred issued to fund these junk mortgages. Its constant repetition reflects the anxiety that bondholders feel about how sound their bond holdings really are. (The stocks of Fannie and Freddie have now plunged to less than 10 percent of their former highs. Investors obviously expect their equity to be wiped out, a la Bear Stearns.)

The word "implicit" means "not explicit." There is a tantalizing hint of what might be, but does not yet exist in a legal sense. Financial free lunchers on Real Estate Finance Capitalism claim to be are innocent victims of an "unexpected" bad turn in the market. (Bad news always is "unexpected" as far as financial spokesmen and media reporters are concerned, just as Claude Rains was "shocked, shocked" to find that there was gambling going on at Rick's Café.)

The distinction between implicit and explicit may be too philosophical for most money managers who work in the financial institutions that have bought Fannie Mae and Freddie Mac bonds and packages of junk mortgages. Most of these apparatchiks don't need much of an education. All they need is greed, and that can't be taught. It is a mentality - and on Wall Street it lives in the short run, from one annual bonus to the next.

Wall Street bonuses are based on how well one "performs" relative to the norm - a Treasury bond's rate of return, or the average mutual fund or money market fund. Anyone can out-perform these averages simply by buying the most risky and hence highest-yielding bonds around.

A replay of the federal S&L insurance crisis: Bailing out the risk-takers, not their victims

The junk bonds issued by corporate raiders were the highest-yielding bonds in the 1980s - before they brought down the S&Ls. Since the Federal Reserve flooded the economy with credit after the dot.com bubble burst in 2000, junk mortgages have been the highest-yielding securities. Meanwhile at the Federal Reserve, Chairman Alan Greenspan deregulated the banking system to let the usual array of financial crooks express the "animal spirits" that he believed were the driving force in his Ayn Rand fantasy world.

The result is a replay of the S&L collapse two decades ago - a financial "golden oldie," so to speak. The S&L bailout is relevant today because proposals to bail out FNMA and Freddie Mac bondholders are distressingly like the bailout of S&L depositors in crooked S&Ls back in the 1980s. Only a handful of S&Ls went under - and they were the notorious risk-takers. Their depositors were not neighborhood moms and pops. They were large institutional savers, who didn't care about risk or crooked behavior, because there was a government guarantee by FSLIC: the Federal Savings and Loan Insurance Corporation. And that bailed out the large depositors.

Fast forward to today. FNMA was shown many months ago to have been cooking the books. But large speculators didn't care. Although there was no official government guarantee, there was an "implicit" protection for risk-takers. Financial insurance firms sharply raised the protection for these two government-sponsored mortgage agencies. But investors still were able to make a few basis points more than normal by buying their bonds.

Should they be bailed out? And if the government does not do so, would this mean that FNMA goes under and the US mortgage market plunges?

Do we really want a new bubble? Or re-industrialization?

Let's take a step back and look at the function that Fannie and Freddie have played in today's Bubble Economy.

Who would one expect the Fed as "board of directors" for the commercial banking system, the Federal Housing Agency (FHA), FNMA and Freddie Mac as creatures of the real estate sector, to support? Ostensibly created to serve "the people," 90 percent of whom are debtors, these institutions actually back the 10 percent of the population who are creditors.

This year already has seen a million foreclosures and the junk mortgage collapse is worsening. Home prices are plunging as interest rates on the euphemistically named adjustable rate mortgages (ARMs) "adjust" in the only direction they ever were intended: jumping up from teaser rates to distress levels. It is more difficult to borrow in today's market. The economy has reached its debt limit and is entering its insolvency phase.

We are not in a cycle but the end of an era. The old world of debt pyramiding to a fraudulent degree cannot be restored, even if the Glass-Steagall Act is not restored to stop the conflict of interest that it unleashed when the Clinton Administration backed Treasury Secretary Robert Rubin and financial lobbyist Greenspan in repealing it. The real estate bubble was made possible by the unique degree to which America's fact population emerged from World War II relatively debt free. Each recovery has taken off from a higher debt level. This something like trying to drive a car with the brakes pressed tighter and tighter to the floor each time there is a stoplight (recession). We have now reached the debt limit, and the economy is stuck. The class war is back in business, with a vengeance. Instead of it being the familiar old class war between industrial employers and their work force, it is more the old pre-industrial class war of creditors versus debtors. Its guiding principle is "Big Fish to Eat Little Fish," mainly by the debt dynamic that crowds out the promised economy of free choice.

This is being portrayed as a post-industrial economy, but it is a much older story. No economy in history ever has been able to pay off its debts. That is the essence of the "magic of compound interest." Debts grow inexorably, making creditors rich but impoverishing the economy in the process, thereby destroying its ability to pay. Recognizing this financial dynamic most economies have chosen the logical response. From Sumer in the third millennium BC and Babylonia the second millennium through Greece and Rome in the first millennium BC, and then from feudal Europe to the Inter-Ally war debts and reparations tangle that wrecked international finance after World War I, the response has been to bring debts back within the ability to pay.

This can be done only by wiping out debts that cannot be paid. The alternative is debt peonage. Throughout most of history, countries have found again and again that bankruptcy - wiping out the debts - is the way to free economies. The idea is to free them from a situation where the economic surplus is diverted away from new tangible investment to pay bankers for the monopoly they alone have been given to create bank-credit and charge interest on it. That is the classical idea of free markets.

Bad debts that are not publicly insured (except by an "implicit" guarantee that they have bought the relevant Congressional committee heads body and soul) are to be replaced with new debts, and new suckers are to be left holding the bag. Bahrainis and Saudis in particular are being courted.

But most of all, there is a public campaign being waged by the FIRE sector (finance, insurance and real estate) to convince the American public that, in the infamous words of Margaret Thatcher, "there is no alternative." (See for instance the Wall Street Journal's excellent coverage of the FNMA/mortgage crisis on July 11, 2002, p. A12.) When one hears this, it means that political censorship is being mobilized to flood the popular media with the intellectual equivalent of sterile fruit flies being release to stop the spread of a threat. All one hears is a barrage of claims that the government must preserve the financial fictions of FNMA and Freddie Mac in order to "save the market."

But just what is "the market" that is to be "saved"? To Wall Street and its Congressional advocates, it is the mass of bad debts growing at compound "magic" rates of interest, beyond the ability of debtors to pay. If the debtors cannot pay, then the Government - "taxpayers" are to pick up the check to Wall Street. Meanwhile, more tax breaks are to be given to leave the finance, insurance and real estate sectors with enough money to "earn back" their losses, by extracting yet more rent and interest from the industrial economy's consumers and wage-earners.

The usual hypocrisy is being brought to bear claiming that all this is necessary to "save the middle class," even as what is being saved are its debts, not its assets. Something must give - and the upper 10 percent of the population wants to make sure that it is not its economic position, but that of the bottom 90 percent. The "way of life" that is being saved is not that of home ownership, it is that of debt peonage to support an unprecedented concentration of wealth at the top of the economic pyramid. Debts are to be honored, although shareholders of FNMA and Freddie Mac probably will be wiped out, as were S&L shareholders in the bailout of S&L depositors in the 1980s.

My modest proposal

There's a simple way to save FNMA's and Freddie's public functions, should they indeed be deemed necessary to keep supporting the mortgage debt market. This can be done without bailing out the speculators who bought the junk mortgages it packaged.

First of all, not all the mortgages that these two agencies have bought or guaranteed are fraudulent. Most are genuine and are being paid. The poor are honest, after all, and think that they should pay as a matter of honor even if it is not in their economic interest to do so when they fall into negative equity territory. Let these mortgages continue to back the existing FNMA and Freddie Mac bonds to the degree that "the market" will support. To the extent that there is a shortfall, let bondholders take a haircut. It will be proportional to the degree of financial and real estate fraud they have enabled. This is the law for all other bondholders. Why make an exception in the present case?

To keep these activities current, let Fannie and Freddie issue a new series of bonds. These will come to be known as the "we won't fake it anymore" series. They would be based on a new honesty, more honest appraisals of the affordability of housing that they were supposed to be promoting all along.

These steps would not cause widespread collapse. But before actually stepping up to save FNMA and Freddie Mac, we should ask whether it would really be a tragedy if their debt functions were to cease. Their role has been to extend the market for mortgage debt, creating opportunities to make money financially in an environment of asset-price inflation - the Bubble Economy. Prior to FNMA and Freddie Mac, banks that issued mortgages held onto them, because there were no outside blind buyers. This was the pre-fraud era. It is now looking like a Golden Age. Housing prices were lower, and buyers did not have to go so deeply into debt to purchase homes.

Banks have given politicians a cover story that to support FNMA and Freddie on the pretense that its packaging and reselling mortgages in big "tranches" provides liquidity. Its defenders claimed to be "modernizing" the real estate mortgage market by creating uniform standards and homogeneous packages. But what was increasingly tainted with junk, putting floor sweepings of ARMs with no-down-payment and NINJA (no income, no job) loans into financial sausages.

What Fannie and Freddie did was to provide a vast new source of demand for mortgages. The effect was to push up housing prices. This has been the great American game for a century. And it has turned increasingly to outside investors (including gullible German banks which were the first to go bust by trusting the U.S. junk mortgage market), swelling the supply of loanable funds that bid up property prices.

The government is now urging the FHA and other government agencies to prop up the mortgage market by issuing zero-down-payment loans and other subsidies. The aim is not to help homeowners - indeed, they will have to pay more if the housing market re-inflates. (Each new economic crisis adds a few new words to the English language. This one is "reflate." Others include NYU Prof. Roubini's "stagdeflation" for a combination of debt deflation of incomes and price inflation for commodities as the dollar sinks in response to the balance-of-payments deficit resulting largely from the war in Iraq. But that is another story. Today's story is all about how Congress is aiming to bail out the banks that have bought or packaged these junk mortgages; and how needless this bailout is, how much simpler and more fair simply to write off the bad debts.

Conclusion

America's $13 trillion in domestic real estate debt is no more payable than is the government's $3.5 billion dollar debt to foreign central banks, or the public debt itself for that matter. Adam Smith remarked over two centuries ago that no government ever had repaid its debts. At that time the aristocracy - the heirs of the Viking warlords who conquered Britain and other European countries and turned their common lands into private property - held most of the land free and clear. Today, real estate has been "democratized," but this has been done on credit. Mortgages are the major debts of most American families. In this role, real estate debt has become the basis for the commercial banking system, and hence the basis for the wealthiest 10 percent of the population who hold the bottom 90 percent in debt. That is what Fannie Mae, Freddie Mac and "the market" is all about.

Neither party in Congress supports a new bankruptcy bill. The lobbying money simply isn't there. So the preferred alternative seems to a new real estate bubble, which means more debt peonage for new home buyers rather than housing falling back to more affordable proportions.

Of course, there is another alternative (TIAA). It is to change the tax system so as to collect rent as the basis for taxation, not for an expansion of debt to the banks. Real estate could free labor and industry from having to pay taxes. Instead, un-taxing property has forced labor to bear the tax burden, and to pay an equivalent sum in interest to the banks as well.

But that is a topic for a future article.