Banking on Bankruptcy

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from Dollars & Sense:



Banking on Bankruptcy
Thoughts on Fannie Mae/Freddie Mac, Commodity Spikes, and the "New Stagflation"
By Larry Peterson



After the stabilization provoked by the government-supported rescue of one of the financial sector's main players, Bear Stearns, in March, the economic focus of most people, including policy makers, immediately turned to the remarkable rise in prices that had been spreading through a worrying extent of the economy for somewhat longer. This trend had been led, of course, by surges in prices of key inputs such as oil and agricultural commodities (and also by gold: though of relatively little industrial use, it retains its traditional popularity as a hedge against inflation—or at least it did until very recently—for many investors). But, despite the clear upward trend, some of these commodities, especially oil, were subject on several occasions during this particular period to huge and rapid—sometimes unprecedentedly so—swings in both directions. And then there was the dollar, which was engaged in a similarly bumpy ride, mainly downwards. But on Friday, July the 11th, the stock of the two major government-sponsored mortgage companies (or Government Sponsored Entities, or GSEs), Fannie Mae and Freddie Mac, fell by more than 50% in the opening minutes of trading in New York; and the focus shifted right back to the specific woes of the financial sector in a twinkling of an eye.

This was ironic in a sense, for it was exactly a year before that interest rate rises, justified at the time by stubbornly increasing prices—especially again, that of oil, but also by rising wages and falling unit labor costs (which corresponds to labor productivity)—precipitated the financial catastrophe that has come to be known as the "subprime crisis." (A quick aside here: just in May, Challenge published the results of a shocking study by Andrew Sum and Paolo Tobar, which indicates that "$32-$37 billion in major Wall Street firms' bonuses in 2006 and 2007 were greater than the annual increases in the wages of 109 million American front-line workers between 2002 and 2007." This suggests that of the feared earnings inflation the Fed is so zealous to combat, the lion's share between 2005-2007 consisted of outsized payouts to movers and shakers on Wall Street—not even in the entire state of New York; and throw in Jersey and Western Connecticut as well. Everyone else was staying above water, if not losing out. So the next time Fed chairman Bernanke or some other such eminent personage starts holding forth about the danger of "inflationary expectations" taking hold, you might wonder why they didn't do what they could to curb executive pay in the financial sector when they had a chance, rather than blaming workers for demanding enough simply to keep up with inflation and rapidly eroding benefits—never mind adequately compensating them for the enormous increases in productivity from 2001-2004, or redistributing some of the ridiculous gains of some of those who, far from contributing to productivity, brought us, and seem to expect us to pay for, the financial crises we're facing now.)

Back to our story, these rate rises considerably decreased the likelihood that borrowers could continue to pay off their mortgages, and the disruption to the flow of income meant that the vast numbers of investors, who had funded the phenomenal growth in the mortgage industry through the kind of securitization that firms like Bear Stearns and others affected, faced potentially dangerous losses as well. Or, the possibility existed that even if the financial firms were left holding the bag, the supply of credit to the whole economy—never mind the grossly oversized housing sector—might dry up. And the likelihood of an unhappy ending was redoubled by the fact that many subprime mortgages were due to reset at much higher interest rates from mid-2007 on. Indeed, prime mortgages are also set to witness a spike in delinquencies, as borrowers who had good credit scores, but no proof of income or assets, join their benighted subprime cousins in falling behind on their payments (which could reset as much as 50% higher for some, and with opportunities to refinance scarce as banks cut back on loans); and many will no doubt decide simply to drop the keys in the mail and send them back to the bank (the famous "jingle-mail" phenomenon), as so many subprime borrowers did. In fact, The International Herald Tribune quoted the president of an investment firm, who went so far as to say: "Subprime was the tip of the iceberg," and that "prime will be far bigger in its impact."

Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are private companies that buy mortgages from mortgage originators and banks and securitize them (by aggregating countless numbers of underlying loans, largely on the basis of risk-levels, and selling the bundled loans to investors as bonds), while guaranteeing the payment of the loans to buyers of the bonds for a fee. And it should be noted that Fannie and Freddie were not involved in the sort of subprime shenanigans that other mortgage originators were: Fannie and Freddie require mortgage buyers to provide documentation of ability to pay. However, Fannie and Freddie, following the familiar pattern, bought up a lot of securities that have become tainted by the subprime affair to hold on their books, essentially as cheap collateral for their rapidly expanding loan-books. ......(more)

The complete piece is at: http://www.dollarsandsense.org/archives/2008/0808peterson.html