The US now has the most socialist financial system in the world outside of North Korea and Cuba. The government takeover of government-sponsored mortgage lenders Fannie Mae and Freddie Mac means that the state now owns 75% of the US housing finance market.
At the same time, the Federal Reserve is providing nearly $300 billion of cash to finance the takeover of investment house Bear Stearns (last March), to provide liquidity for banks, investment houses and brokers in return for all the toxic mortgage-backed securities they own.
The US treasury has taken on to its books $5.2 trillion in Fannie Mae and Freddie Mac liabilities, nearly doubling the debt that the government must finance through the budget. The US government’s debt as a percentage of GDP will thus rise from about 40% to nearly 80%, easily surpassing the majority of European governments’ debt burden.
That is not the end of it. To provide compensation for depositors if their savings come under threat when banks go bust, the Federal Deposit Insurance Corp must rely on monies and lines of credit from the US Treasury. It is going to be badly short of funds soon and will have to ask the government for up to $70 billion. At the same the Federal Home Loans Banks will have to provide liquidity to various private mortgage lenders up and down the country. Already they have lent up to $840 billion. If there are defaults, the Treasury will have to fill the holes.
The irony is that financial markets are likely to greet this largesse from the taxpayer as good news. They will see it as the beginning of the end of the housing downturn. The nationalized companies will let insolvent borrowers off the hook and reclassify their loans as solvent, when they are anything but. However, that will avoid foreclosures. All this will be seen as good for the consumer, banks and the economic recovery. Equity markets might well rally as a result.
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Bad times in the US |
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OECD fiscal balance forecasts as a percentage of GDP |
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Source: OECD |
Government bonds have already rallied on the news of the bailouts of the mortgage lenders and bankruptcy of Lehman Brothers. But that’s because investors quickly rushed to buy safe-haven assets where they can be sure there will a very low risk of default – namely government debt.
GDP deficit
However, don’t expect this to last. The rise in US government debt will mean a minimum increase of 0.5% of GDP on the federal budget deficit, which is already heading upwards as the economic recession starts to bite. Indeed, some estimates forecast that the deficit could hit 7% to 8% of GDP before this decade is out. That is extremely bad news for the value of US treasuries in the longer term.
The safe-haven rally in bonds has also included the dollar. Many reckon that government funding of the financial crisis will hasten prospects for a US economic recovery while Europe and Japan are heading downwards. But all this optimism for US financial assets is wishful thinking.
Sure, when there is a credit crisis, there is nothing wrong with the central bank providing cheap liquidity in unlimited quantities to keep the financial markets functioning, while the insolvent lending institutions are nationalized, reconstructed and sold off. That is the classic way of dealing with a credit crisis. But what is wrong this time is that after the bailout there is no plan to restructure.
Restructuring a bank means writing down the existing shareholders’ investments to zilch; firing the incompetent managers; repossessing the assets of insolvent creditors and writing down the value of the assets and the loans to market value; selling the repossessed creditors’ assets at market prices; recapitalizing the bank to adequate levels; and then reprivatizing the bank.
But this is not what is going to happen. Instead, the whole purpose of the nationalization effort will be to prevent default and provide a prop to the mortgage market and not to allow the issue of insolvency to be cleared by market mechanisms.
There’s no way the administration is going to take any tough decisions ahead of a presidential election. So the issue of what to do will be kicked into the long grass until the end of 2009, when the state-owned mortgage lenders will have to wind down their loans. This will have two consequences. First, the markets that rally will do so only for the short term. Second, the long-term growth and inflation prospects of the US relative to the other major economic blocs will be even further damaged.
Expect a rally in US financial assets but have considerable cynicism about the long-term future of Uncle Sam.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com