Even the most important (and supposedly liberal) economy in the world has its contradictions. And in this continuous deleveraging process that it’s suffering two huge pieces have fallen. Well, in fact, they have not fallen but been saved by the bell, at the last minute, by the American taxpayers. Or maybe not?
Let’s go step by step. This kind of operations are called nationalisations all over the world (and bringing them under government’s control in the US). Now the shareholders and the debtors of Freddie Mac and Fannie Mae have a problem. But the deleveraging process had to stopped somehow, somewhere. And that line was worth defending.
Avoiding the discussion about moral hazard, six months ago I was writing about the Financial weapons of mass destruction unleashed in the US (the party is over) and also about The new cycle of capital recovery (who’s financing your debt now?) Let’s use the same ideas now to seek coherence in the present situation.
Let’s summarise the whole reasoning and see where it leads to:
- Freddie Mac & Fannie Mae’s shareholders (and many other shareholders and creditors too) have lost a lot of money, true. We still haven’t seen that in the news, but a lot of sovereign funds must have lost fortunes. The time will come when they’ll have to account for them.
- Taxpayers will have to pay a lot of money now, true.
- The consequences could be worse if the taxpayers didn’t intervene, so it’s worth doing it, true. This line should not be crossed.
- So we do it, we nationalise Freddie Mac and Fannie Mae. Done. And to avoid moral hazard their shareholders must have an important loss, otherwise the system would be asymmetric. Or did any companies volunteer to share their big gains not so long ago?
- Shareholders and debt holders of those companies must be unhappy and worried about the soundness of the American economic system, reasonable. Wouldn’t you after losing that much? They’ll think twice before investing again in the US. Sensible thought, and yet that’s where our problems begin.
- Taxpayers are paying. I said that in number 2. But, can they afford the bill? The US is a country with a huge fiscal and commercial deficit, so it depends on foreign inflows of capital. Just follow the previous links to my half-year-old articles to see more.
- The taxpayers only have two ways to pay the bill: increasing taxes or further going into debt. I don’t see any of the presidential candidates advocating for higher taxes so I assume it will be the second option. The treasury will have to emit further debt, and not in small quantities. I’m approximating here but, these huge numbers are in order of the current debt volume. In other words, the US debt might be doubling because of these nationalisations.
- Doubling the debt volume means a lot about a country’s ability to repay it: it roughly halves the quality of the debt. We know that the US debt is a high quality debt, but that quality will subsequently be slashed down.
- The world has a few very important lenders, mainly Asian countries. Need I say which one? But they are not that enthusiastic with investing in the US any more. The foreign inflows into the US economy have been steadily declining in the last months.
Now for the conclusion, do we really expect the international lenders to go and help the same country that has given them important losses? Could we have an “holistic” response to keep the international lenders happy without incurring in moral hazard? Will they, after the negative experience, keep buying increasing quantities of worse quality debt?
The equation is something like this:
- ↓↓↓ availability of capital in the markets
- ↑↑↑ losses lenders and investors have suffered
- ↓↓↓ their predisposition to invest again
- ↑↑↑ increase in US debt needed
- ↓↓↓ decrease in the US debt quality
Well, there’s no easy exit to this cycle. The US will be pressured to compensate the international lenders of their loses if they want to keep capital inflows going. But isn’t that strikingly close to the definition of moral hazard? Notwithstanding, which are the other options to keep the flow going?
The deleveraging process is not quite over yet. And the US treasury is constrained between a series of conditions that cannot be all met at the same time. But worse of all, the whole country’s economy virtuous circle is broken and has turned into a vicious one. The economy is not sustainable any more. Houston we’ve got a problem.
On a positive note, there are more sides to this story. Two ideas:
- The US are the main market for those that are financing them. That means that, at least, they are financing a nation that is giving them back part of their finance and holding the activity of their industry. While this cycle exists, things won’t be so grim.
- Other economic areas don’t have this vicious circle, but are falling into stagflation instead. Even with its shortcomings, the US is still a growing economy. There are not that many around. The solvency of the US economy is still holding. And they have the resuscitated dollar.
And another Damocles sword:
- Is this the end of the intervention over Freddie Mac and Fannie Mae? Will these funds be enough? That depends on the still falling value of their assets and their growing insolvencies when people won’t be able to repay their mortgages. Who knows how much money will still have to be injected… and where else.
Gabriel's scarcity rent - it's management stupid! 
Oversea holders of U. S. Federal Reserve Notes (debt) have two options when deciding where to invest said notes: 1. the U. S.; 2. convert said debt to notes of other countries (only beneficial if you are increasing your amount of holding after conversion, worth purchasing goods from countries that use your newly converted “monies”, etc.).
The former is the only option because the countries which have currencies valued > F.R.N.s do not produce/purchase nearly the amount of goods/services produced by the economy of the U. S. This is the most important and only argument that stands the test of time.
When one understands how credit is created in the U. S. then one understands that the NATIONAL DEBT
. . . is nothing more than a number on paper.
Hi Timothy, thanks for commenting.
I knew I needed to add a positive note somewhere: I’m glad I did. The U.S. G.D.P. exceeded $14,312.5 billion with a real growth of 1,9% (source: Bureau of Economic Analysis). The economy is the biggest in the world, and that entails a lot of strength, that’s for sure. If there’s one single economy that can withstand a shakedown like this, it is the US economy.
The losses for Freddie Mac & Fannie Mae are one in a thousand of the GDP, but still a twentieth part of the expected real growth this year. It is a worrying sign, as it is the idea of being “too big to fail” which only means that some companies have the ability of skipping the set of rules that the rest have to abide to.
Still, let’s think for a minute… Are they “too big to fail” or is it that they are deemed to be too strategic to fail? If it was the first thing that would be just an internal U.S. issue, if it was the second, is it that the authorities may be worried about the foreign investors that hold the US economy together?
After all, who is benefited by the intervention? Shareholders are not, that’s for sure. They have to sustain heavy losses. But creditors are. And the shareholders are not sovereign funds: but again creditors are. I read somewhere that the shareholders are mostly small regional US banks, while amongst the creditors there are institutions like the Bank of China.
Need I follow the reasoning? Isn’t the US sending the signal that they are protecting foreign investors with this bail-out at the expense of their own interest? Isn’t it the only reasonable thing to do after chasing investors around the globe and getting $1,000 billion in foreign debt only last june? That’s a huge number.
And $1,000 billion fleeing out, that’s roughly 7.5% of the GDP. That would be a problem.
Bank of China was reducing its exposure to these two companies last June. Yes, capital was fleeing, still slowly but steadily. Only two things were holding them back: geopolitical interests and the treasury assuring them that they would back up this debt if necessary. The time has come to prove that affirmation. Right now they simply have confirmed it intervening. Backing the creditors and not the shareholders. In fact the stock markets have gone up wildly everywhere after the intervention… except in the US.
And if they have confirmed this backing, their pampering of foreign investors must be because foreign investors are essential for the US economy to work. Otherwise, why bother?
Especially when there are other alternatives in economies that, although they stagnated right now, are bigger than the US, like the European Union, with a $18,500 dollar GDP and with a small but positive trade balance with the rest of the world.
I’m pretty sure that the trade deficit is not the end of the world, but it’s much more than a number on a piece of paper. And with the dollar rising it will be harder to manage.
Best regards 🙂
gabriel
Great post.
Some voices crying in the wilderness have been worried for quite a while about one of our largest creditors pulling the plug on us and conquering our country without firing a shot. I just found your blog but maybe that is the subject of your financial WMD article.
What is appalling about the current fiasco is that China et al not only haven’t fired a shot, they have been trying their darndest to keep us alive.
Yes, we are a huge market. On the other hand we also have to pay our debts. Maybe the absolute dollar figure of our national debt doesn’t matter, being just a number on paper, but what does matter is the interest we have to pay on it. I seriously doubt that there is a country on earth which would lend anyone money without getting anything back.
Or are we really so stupid to believe that we are such a great country, so important to the world, that every other country, China included, can’t wait to filll our Christmas stockings with all the dollars and euros and whatever the other currencies are that we want. If we continue on this road, at some time all Americans will be working just to pay the interest on our national debt.
Who gets the last “Laff”-er?
You’re right, our interests are intertwined, mangled together in this global world, yet we are not the same and our strategical interests differ. Many dangerously oppressive things have been done in the name of freedom.
This morning I read in last week’s The Economist, written before this intervention, that the US treasury had to think both in the shareholders of the twin F&F because they were mostly US banks that held their capital there, and the debtors which were mostly sovereign funds.
Well, now we know who they decided to protect: the latter at the expense of the former. Can that be seen as a bow to foreign sovereignty? It can be seen as the most reasonable thing to do too… it depends on the eye of the beholder.
I strongly agree with what you say in your blog that the American public is not explained those things, but kept apart from them with a debate about further tax reductions totally disconnected from reality. And that’s not the best way to face reality.
Best regards
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