Fannie and Freddie Orphaned in the Storm

by
William Krehm

Of all The New York Times stable of economic reporters one of the most talented to my mind is Gretchen Morgenson. In recent weeks she has marched right to the brink of the cliff and looked fearlessly what may lie below. Undoubtedly this unusual degree of frankness of the print media is not unconnected with the crisis that they are undergoing in their own business from the competition of the blogs. However, the greatest still missing ingredient would help us understand how we got out of the Depression of the 1930s, and why, ignoring those dearly bought lessons, we risk heading towards a still greater mess than that of the 1930s. I say “greater,” because the technology of mass extermination has, unlike the teaching of economics, made fantastic progress since those primitive days.

But lets listen to Ms. Morgenson as she recounts the most recent economic shock (Times, 13/07, “The Fannie and Freddie Fallout”): “Its dispiriting indeed to watch the United States financial system, supposedly the envy of the world, being taken to its knees. But thats the show were watching, brought to you by somnambulant regulators, greedy bank executives and incompetent corporate directors.

“This wasnt the way the ownership society was supposed to work. Investors werent supposed to watch their financial stocks plummet more than 79% in less than a year. And taxpayers werent supposed to be left holding defaulted mortgages and abandoned homes while executives who presided over balance sheet implosions walked away with millions.

“Over the course of this 18-month crisis, we have lurched from land mine to land mine. Last week [featured] Fannie Mae and Freddie Mac, the giant government-sponsored enterprises set up to provide affordable housing across the nation. By issuing debt, these shareholders guarantee or own more than $5 trillion in home mortgages. Got that? $5 trillion.

“Because the federal government established the companies, investors view them as backed, at least implicitly, by taxpayers. And that implied guarantee is what drove Fannie and Freddies business models.

“The advantages the companies gained from this unique arrangement were huge. They had to keep less cash on hand than traditional lenders, for example. They also made more money than traditional lenders, for example because they paid less to borrow money in the bond market. These profits enriched Fannie and Freddie shareholders over the years and bestowed significant wealth on the companies executives.”

Now it looks as if the bill for that largess is coming due. Of course, it will be borne by the usual bagholders - US taxpayers.

“For years, anyone warning that Fannie and Freddie should beef up their financial positions was ridiculed and run over by the lobbying machines these companies kept oiled and close at hand. So their lucrative arrangement remained the same: business as usual, with all its riches, was the goal. After all, wasting money by inflating their cash cushions would just crimp their style.

“Suddenly, Fannie and Freddies relatively anemic capital supply is a concern. Last week, Fannies stock plummeted to $10.25, down 74% in 2008. Freddies shares also dived, closing at $7.75, a loss of 77% this year.”

Legal Tender Tied to Subprime House Sales

“ Even as investors were stampeding out of these stocks, the claque in Washington rushed to reassure them. Both Ben S. Bernanke, the Federal Reserve Board chairman, and Henry M. Paulson, Jr., the Treasury Secretary, said the mortgage giants regulators confirmed that the companies were adequately capitalized.

“That was supposed to signal that the companies wouldnt have to raise capital immediately because regulators had the problem firmly in hand. But investors have good reason to be skeptical. In the first half of 2007, both Mr. Bernanke and Mr. Paulson sang a similar tune when they opined that problems in the mortgage market were contained to subprime loans.

“Talk of adequate capital also brings to mind comments made last March, when Bear Stearns was on the ropes, by Christopher Cox, the chairman of the Securities and Exchange Commission. He tried to calm investors by telling them that Bear Stearns passed financial muster. Days later. the firm was toe-tagged.

“Which brings us to the main problem: credibility. Wall Street and our senior regulators seem to be running out of that precious commodity almost as quickly as of cash.

“It wasnt as if this problem came out of left field. Fears that Fannie and Freddie were getting too big have been a recurring theme in recent years. And Congress had ample opportunity to create a new regulator that would be vigilant about ensuring the safety and soundness of both companies.

“But even after and both the Fannie and Freddie companies were found to have accounted for their results improperly. Freddie in 2003 and Fannie in 2004, Congress had failed to act. As a result, Fannie and Freddie were allowed to become high-growth companies and stock-market darlings.”

There should be no surprise that the government officials who cleared the paths of sensational advancement for Fannie and Freddie should have background as corporation executives behind them, or aspired to one after leaving public office. The wave of corruption of elected representatives and officialdom was all-embracing, reinforced by the suppression of the Rooseveltian banking reforms in our universities and the media. It was a seemingly unbeatable combination of planned ignorance of everything we had learned before during and after the Great Depression at a staggering cost of which WWII was only an instalment. When crucial chapters of history are suppressed, the world is reduced to a free field for speculative bank capital to romp in.

Canadas Most Brilliant Monetary Coup

Textbooks have been rewritten to omit what is undoubtedly the most greatest initiative that Canada was able to take among nations - the nationalization of its central bank in 1938. For that opened up the possibility of the federal government financing its investments at clear near-zero interest costs - since the profits of the Bank of Canada come back to the federal government as dividends. And the interest paid by the central bank on the loans made to the provinces by the BoC and even to the municipalities - the latter with the guarantee of either a provincial or the federal government, would also end up with the federal government. That would have made it unnecessary for the federal government to down-load onto the provinces vital social programs without adequate funding to take care of them. This was for no better reason than that the federal government had been bailing out the ever-more deregulated banks from their ever mounting gambling losses in acquiring the “non-banking financial pillars that they had been barred from by the Rooseveltian bank reform that came to serve as model for other countries like Canada. It would have restored some sanity to the constant wrangling over payments and money that the relations of the different government levels of government have become.

Instead, much of what we should learned from our history, has been suppressed. The high price of gasoline and other fuels and the damage to the environment and human health by the pollution of the environment, properly considered must sooner or later lead to our governments realizing that price dimensions are intimately related to the space dimensions over which the goods or the raw materials for their production must travel to be produced and consumed in any given country. We have just begun to learn this - the hard way, with eyes and mind closed. Over several decades the relevant groping of economists towards a recognition of such relationships has been suppressed. So long as it adds the Gross Domestic Product, and the profit rates of our large financial corporations. It was left to the allegedly self-balancing market. The misconceived notion of economic growth at an ever sped-up pace on a finite planet has led to needless mileage and fuel consumption, and damage to our environment, in the interest of higher speculative profits of the financial sector.

This recognition of the space and price dimensions as part of a single inter-related complex is not unlike Einsteins realization that the time dimension is part of an interrelated complex with the three spatial dimensions. But then if governments and universities had suppressed what Galileo and Newton had taught us, there could have been no way in which human kind could have grasped such more involved interrelationships when the time dimension (as in velocity and acceleration) becomes large enough to be picked up in the spatial dimensions. A parallel effect is now being noted today in the space-price dimension complex. Industries that migrated from the US to China, are starting to move back to the US or to Mexico, because the high cost of fuel and congested container space in Asian ports.

However, so long as we take zero inflation enforced by high interest rates as gospel we will be unable to deal with the more realistic problems that are starting to catch up with us.

In the light of that, the dense concentration of housing abandoned because of the subprime crisis, can lead us to some very basic conclusions in orienting ourselves towards a solution of some of the immense problems confronting the world today. It can, for example, lead to a shift of population from home ownership for people of modest incomes in distant suburbs to rental housing built closer to their work-places near city centers or where mass employment is more readily available. But to take care of the displaced families, public housing financing by the government at near - zero cost through our central bank to provide good and new rental housing owned by the government, with adequate parkland and educational and recreational facilities nearby. Government loans comes back to it in the forms of dividends - our central bank was nationalized in 1938, but little use has been made by the government of this facility since the 1970s, since government borrowing was shifted from the Bank of Canada to the private banks in the early 1970s as a means of bailing out the banks from their heavy losses in non-banking speculations that had been forbidden them under the Canadian version of the Rooseveltian restrictions on banks.

Zero Inflation Enforced by High Interest

This - similarly financed through the Bank of Canada though projects of the federal government must include adequate parkland, playgrounds, new schools, that will be very different from inadequately serviced rental communities built several decades ago. In the hands of the federal government financed through the Bank of Canada it will leave the occupants free of mortgage debt. Since the move will be towards from the suburbs towards the center of cities and near the sites of larger industries to save transport costs it will ease the strain on our transportation systems, and hence the pollution of our environment. It will be logical corollary to the high fuel price and the pollution of the environment, that will leave in the public domain land bound to appreciate in value during the expectant usefulness of the new public housing properly serviced with educational and parkland provided in adequate quantity and quality. It would be bringing together several basic discoveries of economic theory during the Depression of the 1930s, WWII, to mention a few, the purposes originally intended for the Bank of Canada Act, which is still on our law books.

The 1980s - An Earlier Gamble on Mortgages

The tale winds on. In 1988, the banks gambling with mortgages just as they did more recently lost most of their capital in the US taking over the S&L mortgage trusts. To reconstitute their capital, the Bank for International Settlements, a sort of central bankers club dedicated to deregulating banks, declared that since debt of advanced countries was “risk-free,” the banks could accumulate as much if without putting down any down payment. As a result the banks of Canada were able to quadruple their holdings of government debt to $80 billion dollars. without putting up a penny of their own money. At the same time the BIS raised interest rates to over 20% to “lick inflation.” What BIS and the central bankers it gathered around it overlooked in the urgency of that bailout was when you raise interest rates pre-existent bonds drop in market price like rocks. It almost brought on a world banking crisis. As a result, the US government not only put together the largest standby fund up to that to avoid a world bank collapse, but actually brought in double-entry bookkeeping, evaluating the depreciated value of all the assets of the federal government. The process was carried back to 1959, and the results turned up for the first time in the statistics of the Department of Commerce but under the heading of “Savings.” Which of course, they were not, since “savings” implies cash or short - term, high-quality securities readily convertible into cash. But a nudge and a wink to the bond-rating agencies sufficed to raise the ratings of government securities, and that in turn brought down the interest rates the government had to pay on its securities. That gave Clinton his second term as president and the United States the high-tech boom that led to the Big Bust of 2000.

Emboldened by the introduction of double-entry bookkeeping into the US government accounts, the Canadian Auditor General refused to approved two successive balance sheets of the federal government in Canada unless this were done in Canada. But after many weeks of arguing with the then Finance Minister Paul Martin during which the Auditor General even accused the Finance Minister of “cooking the books.” Martin agreed to bring in capital budgeting, but only after he had imposed a demeaning declaration to the effect that since no new money had been brought into the Treasury, it would not warrant further programs.

The concern was to defend the priority of the Treasurys resources for bailing out the banks from their every greater involvement in non-banking areas of the financial sector - stock brokerages, insurance, and mortgages.

A low value booked for government assets - even if no longer a token dollar before double entry booking were brought had another purpose. The lower the value the more profitably key government assets - downtown sites in leading cities coast to coast booked at a fraction of their real value, let along their inevitable increase in value in response to any infrastructural improvement of any level of government in the area, or even private developments in the area.

Even the Governments policy of doing its banking with the private banks rather than with its own bank, the Bank of Canada, of which it is the sole shareholder. Let me cite an example.

At the moment in just about every major city across this broad land, choice federal real estate is has been put up for sale on a 25-year lease back arrangement. The government sells the building and leases it back for 25 years. The Normans in Britain almost a millennium ago saw the potential of hanging on to land sites where two Roman Roads crossed. They would never part with the site, but would lease it and/or the building for a century. That is why the Normans prospered far beyond other French noble lines.

On the southern side of Front Street in Toronto is a block of the Post Office running from the central railway station to the west to a theatrical area to the east. Across the road are two bank headquarters of an elegance that I dont believe is matched else or surpassed in the city or I believe the land. Infrastructural developments of any level of government, or any elegant buildings in the area cannot fail to enhance the value of the land under the Post Office, an elegant historical building itself. The official version for the sale is that the Government has not the money to maintain it properly. Ridiculous. Will it have applied for a mortgage from the Bank of Canada, and would the Banks single shareholder have been turned down? Or was it that it continued avoiding a serious appraisal of the building it has put up for sale? It is with fairy stories of this sort that politics are made. Why has nobody in Parliament asked this and other questions? One thing is certain: at the end of the 25-year lease-back the government will not be able to buy back what it is in the process of selling needlessly as a political plum.

And when you start asking, you must continue to enquire for the reason that the Bank of Canada Act is still on our books. Any one can find it through Google and by consulting section 2, subsection 14(b) and 17, 18 (c), (f), (g) you will find that the bank has one shareholder, the government of Canada, in the event of a disagreement with the Minster of Finance, the Minister shall given in writing the course to be followed, the Bank may borrow against funded or unfunded debt of the federal and any provincial government, or any corporation against guarantee of the federal or a provincial government. The latter would include any municipality with the guarantee of the federal or a provincial government.

The Heritage of Brian Mulroney

There remains one question. Why is this document so damning for the governments who have ignored its existence, been allowed to continue as law of the land, utterly ignored? Thereby hangs a tale. It takes you back to the time when Brian Mulroney was Conservative Prime Minister of the land, and Canadas constitution was being formulated. Mulroney proposed that two items be put in the Constitution: (1) that the Bank of Canada is independent of the Government of Canada. This is a most remarkable suggestion, given subsection 17 that sets forth that all the outstanding shares of the central bank are held by the Queen on behalf of Canada; (2) zero inflation must be maintained. Mulroneys Commons Finance Committee turned him down on this, and since then no government has dared raise these matters again - or even mention them. That, unfortunately goes for all parties represented in the Commons or the Senate. It leaves Canadas democracy, well-smoked, hanging from a hook. And during election campaigns it is de rigueur - especially in the hand-picked Canadian Broadcasting Corporation phony discussion groups with a party leader. with somebody in the carefully screened audience, asking the high politician how much the debt will be paid down and when it would be completely discharged? How and when this could happen is a secret. As is what will this good land use as currency, since the debt of the federal government is the only legal tender in the land. Reduce it by 25% and you will worse the depression that is already closing in upon us. Pay it off completely, and you shut down the economy - we become a country without a currency. We could always import some of their currency from Zimbabwe, of course.