There is a sharp upturn in the flow of financial news from the United States of America. From page 6 of newspapers, it has jumped to the front page. It is either about some financial firm going bankrupt or about someone buying it, lending to it or rescuing it. As time goes, the rescuers are less often other firms, and more often one or other arm of the federal government.
Bankruptcy is not a sensational event in the US. Thousands of firms fail routinely; and the government has laid down a drill that is followed whenever a firm goes bankrupt. What happens most of the time is that it is bought up by another firm, which takes over its assets and pays off creditors who want their money back. Occasionally, no firm comes forth to buy the bankrupt firm, and some creditor goes to court, which appoints a conservator, as they call liquidators over there. He sells off the firm or its assets, and pays off its creditors as far as asset proceeds allow. This happens all the time. But this time, somehow, it is big news, because all the failing firms are financial firms.
I would start the story with the election of George W. Bush. Like Manmohan Singh, he has been a spendthrift. Clinton inherited a budget deficit of $290 billion; in his last year he had turned it into a surplus of $526 billion. Then came Bush of the Afghan and Iraq wars. By 2004 he had a deficit of $413 billion; he has been running deficits of that order ever since. During his first presidency, he borrowed to finance the deficit; US national debt rose from $5.7 trillion in 2000 to $9 trillion in 2007. When the interest burden began to weigh, he started to issue non-repayable, zero-interest bonds; they are called currency. The growth of broad money (M3) rose from 4 per cent a year in 2004 to 16 per cent currently.
Money primarily collects in bank accounts. Banks were flush with funds, and tried to lend them out. Credit growth was 5 per cent in 2002; it rose to 10 per cent by the end of 2005. Consumers were not borrowing; they had enough of cars and refrigerators. Nor was industry. So much of the credit went to finance real estate, loans on which increased at 10-15 per cent a year. The proportion of Americans owning their homes went up from 64 per cent in 1994 to 69 per cent in 2004. And as interest rates fell, builders built more homes.
As financial institutions pushed housing loans, the proportion going to more risky borrowers — those with lower incomes, less secure jobs, low savings and less clean credit history — went up. The proportion of loans going to sub-prime borrowers went up from 13 per cent in 1999 to 20 per cent in 2006. Sub-prime borrowers have to pay higher interest because of the higher risk they entail. As more of them borrowed, the interest premium they had to pay should have gone up. Actually, it went down from 280 basis points in 2001 to 130 basis points in 2007 — there was too much money chasing too risky a set of borrowers.
These borrowers began to default. When they defaulted, they were evicted and their houses placed on the market. That increased the supply of houses on the market, and brought down the demand for new houses. In December 2005, 6.6 million homes were sold; a house took five months to sell on the average. By September 2007, monthly sales were down to 5.2 million homes, and the mean time taken to sell a house had gone up to ten months. In 2005, 28 per cent of the houses were bought as investment, and 12 per cent were holiday homes. As the time to sell went up, speculators and investors in second homes stopped buying.
Mortgage lenders themselves borrow money to lend — usually by selling bonds on the market. Most of these bonds were “securitized” — they were backed by mortgages on a set of properties. When house owners began to default on their loans, mortgage lenders’ interest income declined. They resumed the houses. But soon house prices began to fall; lenders could no longer get their money back by selling the houses. They could not repay the bonds on their due dates.
That is what happened to Bear Stearns. It was heavily involved in mortgage lending. On Friday the 14th March 2008, there were widespread rumours that Bear Stearns would default on Monday. Over the weekend, treasury and Federal Reserve officials talked to tycoons on Wall Street, and persuaded J.P. Morgan and Chase to buy Bear Stearns for a throwaway price after guaranteeing $29 billion of its assets.
In July there were rumours about Indymac Bank, which too had financed mortgages. Depositors ran to retrieve their deposits. On July 11, as the bank came close to running out of money, Federal Deposit Insurance Corporation nationalized it. FDIC is likely to pay out $8.9 billion — one-sixth of its total assets — to bail out Indymac.
The next to be swept off were Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac). Fannie Mae was created by President Franklin Delano Roosevelt, who wanted to stimulate home ownership, in 1938. He had earlier created Federal Housing Administration to insure mortgages. But banks and mortgage lenders did not see why they should pay FHA for insurance. So Roosevelt set up Fannie Mae to buy mortgages guaranteed by FHA, and thereby made insured mortgages marketable. In 1968 it was privatized, and became a mortgage refinancing company; Freddie Mac was created to give it competition. By 2008, Fanny Mae and Freddie Mac owned half of the $12 trillion of mortgages. They were clearly vulnerable to the crisis, and were placed under conservatorship on September 7.
Fanny Mae and Freddie Mac were refinanciers, and would not be in danger unless the mortgage lenders refinanced by them went down. If the latter went down, the US government still had the choice of bailing them out; it would have cost less, since all the borrowers would not have failed together. Why, then, did it nationalize Fanny Mae and Freddie Mac?
It was because China was a big investor in both. It has invested $376 billion in US government agencies; total foreign holdings in such agencies are $1.5 trillion. China’s dollar-denominated debt is $1.3 trillion. If it lost confidence in the US dollar and began selling its investments, so would India, and Brazil, and Saudi Arabia, and so on. The prices of US government agencies’ bonds would crash, and interest rates would shoot up. The US dollar would collapse, fuelling inflation,
For historical reasons, the US has a great variety of financial regulators who do not always work together; and it has developed a complex, interdependent financial system which carries high systemic risks. Hence it will have eruptions of its financial volcano from time to time, and they will be met by ad hoc executive remedies. The remedies introduce instability of unexpected sorts. So I do not think that sensations have ended; there is doubtless still more news to come.
