The Global Sociology Blog

I have already posted on the credit crunch that has afflicted first the American economy, then other countries as well, in typical globalizing fashion. But this weekend has brought more bad news with the not-very surprising bankruptcy of Freddie Mac and Fannie Mae with an anticipated bailout from the US Federal Reserve. As the Guardian states,

"The debts of both institutions dwarf those of rivals. Fannie Mae has total debts of about $800bn (£400bn), while Freddie has about $740bn. They account for more than 50% of the US mortgage market.

Fannie Mae was due today to carry out a pre-planned sale of $3bn of short-term debt. US treasury officials were telephoning Wall Street banks at the weekend to ensure that they still planned to bid for the securities, as they would in more normal times. It is understood that treasury officials were disappointed by the reaction and moved quickly to bring forward government rescue plans

On Friday, the lenders were forced to refute rumours that they were insolvent by insisting they had sufficient capital to see them through the worst housing market downturn in at least 25 years.

George Bush and Paulson also came out with public support for the government-backed lenders in the knowledge that a collapse of either would deal a massive blow to an already fragile economy and banking sector.

The two companies are widely viewed as too big to be allowed to fail. Their share prices tumbled again last week and are now at only a fraction of the level of a year ago.

Another big mortgage lender, IndyMac, was seized by US regulators on Friday as panicked investors queued to withdraw money from the California-based bank. Its collapse is the third-biggest banking failure in US history."

It is always very interesting to see that in a country where belief in the capitalist system is so strong that there is a need for massive government intervention to save the market from itself. The debate over whether or not the American economy is in a recession is largely sophistry at this point. The reality is that things are really bad and that this awful economic situation is particularly visible in two areas: mortgages and gas prices… the middle classes are hurt in both areas and the lower classes in mostly the gas prices area.

Obviously, the American investor and capitalist classes have shown no rationality or wisdom in their actions of the past 5 years, cheered on by talks of the ownership society and a Fed policy of low interest rates. What will the bailout be, exactly, for Freddie Mac and Fannie Mae? According to Ian Welsh (and if you are not reading Ian Welsh’s economic posts at Firedoglake , what the heck is wrong with you?):

• The Fed will buy stocks in both companies
• The Fed will extend larger credit to them and larger load facility

Again, according to Welsh, what should be done on the long-term for this situation?

"As best I can tell (and I sure could be wrong) this sort of bailout is unprecedented. When Chrysler was bailed out the government loaned it money, it didn’t buy an equity share. Assuming a long time horizon the equity share will probably turn a profit, mind you, but the moral hazard is extreme. Private investors should not be bailed out to this extent by public money.

The board should be sacked. Bonuses should be clawed back. The books should be given a full audit and charges should be laid against those who engaged in illegal activities including breaking their fiduciary duty to investors.

Fannie and Freddie should be explicitly taken over by regulators—they clearly aren’t capable of running themselves, and I don’t see why if they’ve bankrupted themselves it makes any sense to allow them to continue to make any of their own decisions, even if they are subject to "supervision".

Being responsible, being a rugged investor, means taking your losses. Not coming to Uncle Sam every time you lose, whining for a handout."

Fannie and Freddie are too big to fail. But their investors and owners aren’t too big to pay for their failure. Keep the issuing of mortgages and the mortgage market functions they provide going, but there’s no reason to do so under current management or ownership and no reason why folks who bought their debt should be paid back more than if we allowed Fannie and Freddie to go bankrupt.

Which gets me to another point: moral hazard . Isn’t this supposed to be the rule of the game for us? Wasn’t this partially the rationale for the credit card industry-friendly bankruptcy reform? That we need to take responsibility for our actions and that if we were to be shielded from said consequences (well, the bad ones, that is), then we would never learn to behave responsible and we would make risky and reckless economic decisions: like spending too much on our credit cards or getting saddled with unaffordable mortgages.

Somehow, this logic never seems to apply to investors and large corporations. Somehow, it is acceptable that for them, the government ignores the rationality of the invisible hand, and comes to the rescue with taxpayers funds. Can anyone say Savings and Loans ?

On this, Ian Welsh again points us to this article by Gretchen Morgenson:

"IT’S dispiriting indeed to watch the United States financial system, supposedly the envy of the world, being taken to its knees. But that’s the show we’re watching, brought to you by somnambulant regulators, greedy bank executives and incompetent corporate directors.

This wasn’t the way the “ownership society” was supposed to work. Investors weren’t supposed to watch their financial stocks plummet more than 70 percent in less than a year. And taxpayers weren’t supposed to be left holding defaulted mortgages and abandoned homes while executives who presided over balance sheet implosions walked away with millions. (…)

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 Freddie’s 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 on their mortgages than lenders 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: United States taxpayers. You and me."

Back to moral hazard? How these greedy and reckless investors learn their lessons? My guess is they won’t have to. The government will come to the rescue. There will be big winners (not the average taxpayers, not the middle class… hey, we got our $600 stimulus, so, according to Phil Gramm, we should stop whining). And this means that once we have weathered this crisis, we can be sure that there will be a next time as we are in a crisis-prone system with no decent regulators.

Even more cynically, Welsh again:

"As for the regulators, they are all captured either by the revolving door between industry and government or by academic ideology which doesn’t really believe in regulation and which believes that risk can be managed through mathematical models, without recognizing the fundamental limitations of mathematical models – that even on the rare occasions when they work, they don’t work if the numbers in are wrong, and those numbers are always wrong if it’s in people’s interest to lie about them and you don’t bother to check because it’s in your interest to let them lie.

Regulators who don’t believe in regulation can’t regulate. Executives whose real job is to grow their bonuses will do that, no matter what the cost to anyone else.

And until we remember rule #1: "don’t reward people for bad behaviour" this sort of thing will just keep happening."

Don’t count on it.

None of this has escaped the attention of the foreign press, of course, as illustrated by this interview of Jeff Madrick is director of policy research, Schwartz Center for Economic Policy Analysis, The New School with Le Monde.

The bottom line is this: none of these developments are surprising. There was writing on the wall for anyone willing to pay attention, starting with the unleashing of easy credit and the following speculation (the housing bubble) on mortgages and HELOC. But Madrick points out that that one form of American exceptionalism is its extreme reliance on credit (see: national debt). Up until 2006, no one in the investing world was much concerned. However, economists and others should have paid attention to the combination of growth with stagnating, if not decreasing, purchasing power. For the average American household, purchasing power is now lower than it was when George W. Bush became President.

Even if lower and middle classes gained during the Clinton era, it was not enough to compensate for the income losses attributable to Reaganomics. However, Clinton was never economically revolutionary, especially in the domain of access to credit and ownership. And let’s not forget Alan Greenspan’s role in fighting (imaginary?) inflation and protecting speculative profits.

The consequences of this are now well-known: greater inequalities, some very big winners, a lot of not quite losers but not winners either, and not much social mobility for the majority (posts to come on the issue of social classes in the United States). More and more, one’s birth position on the social ladder determines a great deal about one’s (Weberian’s) lifechances.

One of the consequences has been increased indebtedness and low savings rates. It is a system built on sand and risk with very very limited safety nets for the lucky few, and economic downfall for many (now deprived of the protections of bankruptcy). Madrick clearly blames economists for maintaining the illusion of the system.

[As an aside, I did know that the unemployment figures do not reflect actual unemployment, but I did not know that the price of oil and food items are not counted as part of the calculations of inflation, because they're considered too volatile. Thanks for that Mr Madrick]

What this all means is that the next president will have very limited margin of maneuver. And, if that next president is a Democrat, and he/she decides to raise taxes, wait for the howls from the conservative and neo-liberal circles that got us into this mess in the first place.

Madrick adds to all this the cost of education, infrastructure, and health care and concludes that the American economic system that has prevailed since the 1970s is now finished, and can be pronounced a massive failure.