Posts Tagged ‘Fannie Mae’

Is this the beginning of the loss of confidence in fiat money?

Sunday, September 21st, 2008

Events from the past week are tumultuous. It started from the nationalisation of Freddie and Fannie (we were mulling about the implication of nationalisation 2 months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?). Then came the bankruptcy of Lehman Brothers and takeover of Merrill Lynch. Then we have the nationalisation of AIG. Gold prices surged by more than US$100 in two days (it had declined since), which was the most rapid surge in 26 years. At the same time, the Dow plunged by more than 400 points. It looked as if there was a panic from stocks straight to gold, which meant even cash was distrusted.

Then we have another massive rally in stocks for the past two days when there was hope that the US government, in conjunction with the Federal Reserve are doing something to solve the root of the rot in the financial system. Reports come out that they are planning to use taxpayers’ money to buy up bad assets at sale price. As always the case, the devil is in the details. At this point in time, there is no definitive figure on the cost. Make no mistake about this: this is no trivial task. As this New York Times article reported, Ben Bernanke warned the Congressional leaders,

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program ?Good Morning America,? the congressional leaders were told ?that we?re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.?

Mr. Schumer added, ?History was sort of hanging over it, like this was a moment.?

When Mr. Schumer described the meeting as ?somber,? Mr. Dodd cut in. ?Somber doesn?t begin to justify the words,? he said. ?We have never heard language like this.?

By now, it should be clear that this global financial disaster has the potential of even surpassing the Great Depression of the 1930s!

Is this crisis a surprise? If you listen to the mainstream economic schools of thought, central bankers, mainstream financial media, captains of the financial industry and so on, it looked as if this looming financial disaster is something that no one can see coming. The common underlying excuse (that was un-said, un-written but implied) goes something like this: “No one could ever foresee this! It’s impossible! Only hindsight can tell!”

Now, we would like to make it clear that this is completely false. Please note that we are not accusing individuals of lying. Instead, our point is that this excuse is a sign of collective mass delusion. If you look at the 6000 years worth of the history of human civilisation, you will find that humanity is repeatedly capable of mass delusions. Always, only the minority could see through the lie. In this case, students and practitioners of the non-mainstream Austrian School of economic thought SAW IT COMING. Some of them sounded the alarm as early as 2004! To press our point further, let’s us show you the chronicle of our warnings in this blog since 2006…

  1. In May 2008, when the world was in denial about the precarious state of the global financial system, Satyajit Das warned that the credit crisis was just the end of the beginning (see Is the credit crisis the end of the beginning?).
  2. Back in November 2007, if you look at the list of major US financial institutions that was compiled by Nouriel Roubini at How solvent are some of the major US financial institutions?, only half of them are left standing. Interestingly, Merrill Lynch was the safest among the insolvents and today, it failed to live. If Merrill Lynch was insolvent, what about the remaining ones today (i.e. Goldman Sachs, Morgan Stanley, Citigroup)?
  3. In June 2007, in Epic, unprecedented inflation, we warned that

    How much longer will the roaring global economy fly? We do not know the answer, for this boom may last longer than what we anticipated. However, please note that in the entire history of humanity, all bubbles (and we repeat, ALL) burst in the end. Thus, a global painful hangover will ensue?the greater the boom, the more painful the eventual bust. This is the theme that we had repeated many times.

    Thus, do not be surprised if a second Great Depression were to strike.

  4. In the same month, the Bank for International Settlements (BIS) warned that the world was in danger of another Great Depression (see Bank for International Settlements warns of another Great Depression).
  5. Back in January 2007, in Spectre of deflation, we wrote that

    But we smell danger.

    It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

  6. In the same month, Trichet, the president of EU central bank warned of a coming asset re-pricing (see Prepare for asset repricing, warns Trichet).
  7. Back in November 2006, in How will asset-driven ?growth? eventually harm the economy?, when the global economy was still booming in apparent ‘prosperity’, we quoted the late Ludwig von Mises (the in which the Mises Institute of the libertarian Austrian School of economic thought is named after) and warned that

    That collective error in judgement resulted in the economy misallocating scarce resources into housing sector?in the case of the US, a significant proportion of the jobs created during the asset-driven ?growth? was related (both directly and indirectly) to the housing boom. Since economic resources are always scarce, any misallocation of it implies an opportunity cost on the other sectors of the economy. The result is a structural damage to the economy that can only be corrected through a recession.

    This is the reason why we believe a recession is on its way.

  8. In October 2006, we quoted the late Dr. Kurt Richeb├Ącher (an Austrian School economist) and questioned in The Bubble Economy,
  9. These are some of the serious questions we would like to ask:

    1. As the US spends its way into economic ruin, its economy is being damaged structurally. How much longer can the US sustain its colossal debt?
    2. Right now, the US housing bubble is deflating. Will it eventually burst and wreck havoc on the rest of the economy?

Other contrarians who sounded the alarm long ago (and we quoted often) include Marc Faber, Jimmy Rogers, Robert Shiller, Peter Bernstein, Nouriel Roubini and our local Aussie economist, Professor Steve Keen.

Our readers should, by now, appreciate the colossal magnitude of this financial crisis. When you listen the media, the phrase “since the Great Depression” is often mentioned. Make no mistake about this, this has the potential to be worse than the Great Depression (note: we are NOT predicting that it will happen).

The world’s stock market is rallying in the hope that the US government’s plan to nationalise the financial industry will be successful in stopping the core of the rot. New legislations has to be rushed through Congress by the end of next week to change the rules to make the plan legal. As in everything done in haste, we believe there will not be enough thought put into them to understand the long-term ramifications. It is probable that once the changes are in place, they will not be revisited again.

As we warned in Recipe for hyperinflation,

There is no way any politician can sell the message that America needs a severe recession (or even a depression) to cleanse the economy from the gross excesses, imbalances, blunders and mal-investments. Thus, it is very likely that they will have to fight deflation till the very bitter end, till the last drop of blood from their last soldier. Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilisation.

How is the US going to repay its national debt?

Wednesday, September 10th, 2008

As we all know, Fannie Mae and Freddie Mac were being nationalised a couple of days ago. The US government has put in $US1 billion of new capital (in the form of preferred shares) and says it might put in up to $US200 billion more. At the same time, it will take over the management of these two companies. Consequently, the stock market all over the world cheered this news in exuberance.

This is a farce.

There is a cost to this nationalisation, which as we said two months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?,

The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.

Now consider the situation of the US government budget as reported in ‘Frannie’ bailout heavy with irony:

According to the US Government’s Accountability Office the national debt stood at $US4.4 trillion early this year. Unless the habit of deficit spending is arrested quickly this figure will double in the next ten years.

Meanwhile, the social security system faces an unfunded liability estimated by the Government Accountability Office at $US6.7 trillion and the unfunded liability of Medicare is $US34 trillion.

If the US government has to bail out more and more blow-ups in the financial system, there is only one way the level of national debt can go: up and up to the sky. It has come to a stage that the word “billion” is not enough to describe the magnitude of the debt- “trillion” has used instead. That level of debt is approximately $150,000 for every man, woman and children in the United States.

Is the US government going to pay all these debt by raising taxes? With rising unemployment, record levels of private debt and wobbly economy, do you think this idea can ever be entertained? If it is politically impossible to raise taxes, what else can be done? Default or print money?

Strangely, the market reacted to this news by bidding up the US dollar.

How do we all pay for the bailout of Fannie Mae and Freddie Mac?

Monday, July 14th, 2008

Last week, the US Federal Deposit Insurance Corporation (FDIC) took over IndyMac, an insolvent US$32 billion Californian mortgage bank. As if this is not bad enough, two of the America’s largest government-insured mortgage lender, Freddie Mac and Fannie Mae, were losing the market’s confidence in their solvency status. The level of confidence was so low that both the Treasury and Federal Reserve had to step in over the weekend to announce their plan to prop them up. This look to be reminiscent echo of the Bear Stearns bailout in March this year (see New tricks required to bail out financial system).

For those who do not yet already know, Freddie Mac and Fannie Mae are US government-sponsored enterprises (GSE) in which their bonds are insured by the US government. That is, if the US home-owners default on their mortgage debt, the US government will ‘insure’ the shortfall between what they are obliged to pay to their investors and lenders and what they collect from the impaired mortgage debt payments. Now, they can be regarded as insolvent. As we explained before in Banking for dummies,

… the banking business is a balancing act of managing a portfolio of assets and liabilities.

This means that Freddie Mac and Fannie Mae, thanks to the rising debt default of American mortgages, is failing to do a proper job in the balancing act. As we explained with an example in De-leveraging in the real economy- mortgages, with falling house prices and rising debt defaults,

… if house price goes down by more than 10%, then the home ?owners? will not only lose their savings for the 10% deposit, they will still owe the bank money after the house is foreclosed. In the US, house prices have fallen by 13% in one year. So, you can imagine that there will be a lot of misery going on.

Make no mistake about it: this development is highly serious. To give you a sense a scale of the problem, consider this (as reported in this news article- Federal Reserve to rescue US mortgage giants):

  1. Both of them owns around US$5 trillion worth of mortgage bonds, which is almost half of all mortgages in the US.
  2. US$ 5 trillion is the GDP of Japan, the world’s second largest economy.
  3. As at June 2007, foreigners hold US$1.3 trillion long term debts issued by all GSE (which includes Freddie Mac and Fannie Mae). This was 21.4 percent of the total debt. China and Japan holds US$376 billion and US$229 billion of these debts respectively.
  4. The rest of them are held by mum and dads, state and local governments, banks, insurance companies, pension funds, retirement funds, money markets, managed funds and so on.

As you can see, if Freddie Mac and Fannie Mae fail, it will not not just affect the US. Financial assets all over the world will be affected. It could be your superannuation and pension funds holding the bag of worms!

We believe the de-leveraging process still has to continue (see Is the credit crisis the end of the beginning?), it will only be a matter of time before Freddie Mac and Fannie Mae will really become insolvent. If a US government-insured bond becomes defaults on its debt, it will be as good as a default by the US government on its debt. If that ever happens, you can be sure this will descend into an extremely ugly global US dollar crisis. Therefore, both of them are too big to fail.

The only way out of this is, as we explained before in Recipe for hyperinflation,

… once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.