Bailing out the Bubble's Enablers
[Michael Hudson is Chief Economic Advisor to Dennis
Kucinich and the Kucinich-for-Congress campaign. A former Wall Street
financial analyst, he is Distinguished Research Professor of Economics
at UMKC, and author of
Super Imperialism: The Economic Strategy of American Empire
(new ed. Pluto 2002), and Debt and Economic Renewal in the Ancient
Near East (CDL Press, 2002). This article was written during 2002]
When millions of homeowners see the price of their homes falling
below the mortgages they owe, there are two possible responses. The
first is to re-set bad debts at levels that owners can pay. This
write-down is in keeping with the direction of legislation since the
13th century favoring debtors more than creditors. It would restore
balance between what people earn and what they can afford to pay for
This is not the path that Congress is taking. Instead of bringing
debts within the ability to pay, its banking and real estate
committees are seeking to re-inflate housing prices. The hope is to
enable existing debtors on the brink of default to get their mortgage
lenders off the hook by selling out or borrowing on even easier terms
from the Federal Housing Administration (FHA), leaving it rather than
Wall Street holding packages of junk mortgages. This would bail out
financial institutions stuck with some of the $5 trillion in mortgages
guaranteed by the Federal National Mortgage Association (FNMA, or
Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), as
well as the monoline default-insurance companies on the hook and whose
IOUs have now sunk to junk status themselves.
The Democratic congress pushes for American families to pay
higher home prices
These are the major campaign contributors and lobbying powers to whom
Congressional banking committee heads are giving priority. Led by
Democratic senators Charles Schumer from Wall Street and Christopher
Dodd from Connecticut's insurance industry, and supported by
Congressman Barney Frank, Congress is seeking to bail out the bubble's
sponsors, not its victims. Their plan is to re-inflate the housing
bubble to keep it growing at least long enough for the largest banks
and other financial speculators to dump their riskiest holdings, whose
book value is purely fictitious, although given the usual AAA
whitewash from the leading bond-rating agencies, which themselves are
now under investigation for a fatal conflict of interest between the
research and sales arms, Arthur Anderson-style.
Dealing as they do with real estate, and hence with local urban
politics where most of the property values and maneuvering occur,
Fannie Mae and Freddie Mac are largely Democratic creations. James A.
Johnson ran Fannie for most of the 1990s and was its main lobbyist.
Until June he headed Barack Obama's vice-presidential search team, but
resigned when it was revealed that he got mortgages on unrealistically
favorable terms from Angelo Mozilo's notorious Countrywide Financial.
FNMA's former head, Franklin D. Raines, was President Clinton's budget
chief. He was forced to step down when serious accounting problems
were discovered. Other Fannie apparatchicks include Jamie Gorelick,
former Clinton deputy attorney general, and Thomas E. Donilon, Clinton
chief of staff to the secretary of state.
To be sure, political opportunism leads Fannie and Freddie to cover
all the bases, becoming known for hiring relatives of powerful
politicians wherever they may be in a position to help. But at least
this time the problem is not George Bush's fault. The
Wall Street Journal seems closer to reason than the Democratic
Congress. Over the weekend its editorial clarified what socialists
since Marx have been saying: "What taxpayers need to understand
is that Fannie and Freddie already practice socialism, albeit of the
dishonest kind. Their profit is privatized but their risk is
socialized." Calling FNMA and Freddie "high-risk monsters,"
the newspaper noted that "Wall Street and the homebuilders also
cashed in on the subsidized business, and also paid back Congress in
cash and carry." It concluded by questioning whether these
government-sponsored enterprises (GSEs) were justified at all. "Apart
from outright failure, the worst scenario would be a capital injection
that left the companies free to commit the same mayhem all over again
two or 10 years from now."
In a separate article the Journal noted that, "On a
fair-value basis, the company [Freddie Mac] had negative net worth of
nearly $17 billion." The problem is that there is no "market"
-- that is, no supply of equally gullible buyers -- to take on these
bad loans, except at distress prices. Through short-term greed and
incompetence, the home-debt industry has pawned off highly
debt-leveraged mortgage loans drawn up from fraudsters. I cannot
actually call them crooks because instead of being indicted, they have
been rewarded with tens of millions of dollars in bonuses for making
so much money for the finance, insurance and real estate sectors as
Their place is to be taken by the government as bad-debt buyer of
last resort. I suppose this might be called Finance Socialism -- the
stage at which it becomes necessary to rescue Finance Capitalism, at
least its largest institutions ("too large to fail") at the
top of the economic pyramid. I suppose it might be called "real
estate finance capitalism." But in Washington-talk it is
euphemized in the Democratic Party's usual populist garb as "democratizing
property" and "increasing homeownership," by which is
meant indebting a rising share of the population to the point where
carrying their mortgage absorbs most of their disposable personal
Can a new real estate bubble be inflated?
The fact remains that like every financial bubble in history starting
with England's South Sea Bubble and France's Mississippi Bubble in the
1710s nearly three centuries ago, today's bubble has been sponsored by
the government. Forget the "madness of crowds" free-market
propaganda. Insiders and enabling politicians always try to blame the
victim. The reality is that Fannie, Freddie and the FHA gave a patina
of confidence to irresponsible lending and outright fraud. This
confidence game led them to guarantee some $5.3 trillion of mortgages,
and to keep $1.6 trillion more on their own books to back the bonds
they issued to institutional investors. Their strategy has been to
issue bonds paying fairly low interest rates, and use the proceeds to
buy mortgages yielding somewhat higher rates. This kind of
interest-rate arbitrage is what the S&Ls did in the 1980s - a
relevant parallel, as I will discuss below.
The myth is that Fannie's and Freddie's role is simply to spread
homeownership by making it affordable for more of the population.
Fannie Mae was established in the Depression, in 1938 as part of
Roosevelt's New Deal, and privatized in 1968. Freddie Mac was
established two years later, in 1970, to buy up S&L mortgages and
give "liquidity" to their mortgages, by developing markets
outside of the banks and S&Ls that originated these loans. But
this turned out to be the "original sin," so to speak.
Outside investors were obliged to place their trust in the mortgage
originators - banks, S&Ls and mortgage brokers, whose ranks are
filled with fraudsters and crooks.
Whatever we may call it, their dream is to bring back the seeming
golden age sponsored by Alan Greenspan at the Federal Reserve. It was
a decade of quick mortgage billionaires writing fictitiously high
mortgages and selling them off to pension funds and to German and
English bankers eager to seek a few extra fractions of a percentage
point in current income so as to justify a big bonus by claiming to
outperform more reality-based money managers.
All this is as American as apple pie. Altruistic political talk
aside, the reason why the finance, insurance and real estate (FIRE)
sectors have lobbied so hard for Fannie and Freddie is that their
financial function has been to make housing increasingly unaffordable.
They have inflated asset prices with credit that has indebted
homeowners to a degree unprecedented in history. This is why the real
estate bubble has burst, after all. Yet Congress now acts as if the
only way to resolve the debt problem is to create yet more debt, to
inflate real estate prices all the
more by arranging yet more credit to bid up the prices
that homebuyers must pay. The plan is thus to pretend that the Bubble
Economy's financial unreality may be made real by Finance Socialism.
Can the plan work? The reason why Fannie and Freddie have been able
to borrow at lower rates than their rivals is because their public
sponsorship led investors to believe that there was an implicit public
guarantee not to let them fail. And in view of the fact that these two
agencies account for some $5 trillion in mortgages - nearly half the
nearly $12 trillion U.S. home mortgage market - they do indeed seem to
be "too big to fail." The face value of mortgages they have
guaranteed is nearly as large as the entire U.S. federal debt held by
the public. This means that the nominal federal debt would double if
they went under. But at least the government can always print money,
while the real estate backing the mortgages guaranteed by Fannie and
Freddie (or held in their own accounts) is plunging in price into the
dreaded Negative Equity territory.
But on their shoulders ride the hope of re-inflating housing prices
to bail out the financial managers who sought to make money by debt
creation rather than tangible capital formation. So the question is
whether housing prices can be raised to a level that oblige families
to run into even more debt than they now are carrying - with even
lower down payments, subsidized at public expense.
In this case the subsidy would not really be for homeowners at all,
but for the financial system's mortgage holders. The aim would not be
to make housing more affordable, but less so!
Most investors view the situation as being more political than
strictly economic. One hears again and again these days about the "implicit"
government guarantee to make good on the bonds Fannie and Fred issued
to fund these junk mortgages. Its constant repetition reflects the
anxiety that bondholders feel about how sound their bond holdings
really are. (The stocks of Fannie and Freddie have now plunged to less
than 10 percent of their former highs. Investors obviously expect
their equity to be wiped out, a la Bear Stearns.)
The word "implicit" means "not explicit." There
is a tantalizing hint of what might be, but does not yet exist
in a legal sense. Financial free lunchers on Real Estate Finance
Capitalism claim to be are innocent victims of an "unexpected"
bad turn in the market. (Bad news always is "unexpected" as
far as financial spokesmen and media reporters are concerned, just as
Claude Rains was "shocked, shocked" to find that there was
gambling going on at Rick's Café.)
The distinction between implicit and explicit may be too
philosophical for most money managers who work in the financial
institutions that have bought Fannie Mae and Freddie Mac bonds and
packages of junk mortgages. Most of these apparatchiks don't need much
of an education. All they need is greed, and that can't be taught. It
is a mentality - and on Wall Street it lives in the short run, from
one annual bonus to the next.
Wall Street bonuses are based on how well one "performs"
relative to the norm - a Treasury bond's rate of return, or the
average mutual fund or money market fund. Anyone can out-perform these
averages simply by buying the most risky and hence highest-yielding
A replay of the federal S&L insurance crisis: Bailing out
the risk-takers, not their victims
The junk bonds issued by corporate raiders were the highest-yielding
bonds in the 1980s - before they brought down the S&Ls. Since the
Federal Reserve flooded the economy with credit after the dot.com
bubble burst in 2000, junk mortgages have been the highest-yielding
securities. Meanwhile at the Federal Reserve, Chairman Alan Greenspan
deregulated the banking system to let the usual array of financial
crooks express the "animal spirits" that he believed were
the driving force in his Ayn Rand fantasy world.
The result is a replay of the S&L collapse two decades ago - a
financial "golden oldie," so to speak. The S&L bailout
is relevant today because proposals to bail out FNMA and Freddie Mac
bondholders are distressingly like the bailout of S&L depositors
in crooked S&Ls back in the 1980s. Only a handful of S&Ls went
under - and they were the notorious risk-takers. Their depositors were
not neighborhood moms and pops. They were large institutional savers,
who didn't care about risk or crooked behavior, because there was a
government guarantee by FSLIC: the Federal Savings and Loan Insurance
Corporation. And that bailed out the large depositors.
Fast forward to today. FNMA was shown many months ago to have been
cooking the books. But large speculators didn't care. Although there
official government guarantee, there was an "implicit"
protection for risk-takers. Financial insurance firms sharply raised
the protection for these two government-sponsored mortgage agencies.
But investors still were able to make a few basis points more than
normal by buying their bonds.
Should they be bailed out? And if the government does not do
so, would this mean that FNMA goes under and the US mortgage market
Do we really want a new bubble? Or re-industrialization?
Let's take a step back and look at the function that Fannie and
Freddie have played in today's Bubble Economy.
Who would one expect the Fed as "board of directors" for
the commercial banking system, the Federal Housing Agency (FHA), FNMA
and Freddie Mac as creatures of the real estate sector, to support?
Ostensibly created to serve "the people," 90 percent of whom
are debtors, these institutions actually back the 10 percent of the
population who are creditors.
This year already has seen a million foreclosures and the junk
mortgage collapse is worsening. Home prices are plunging as interest
rates on the euphemistically named adjustable rate mortgages (ARMs) "adjust"
in the only direction they ever were intended: jumping up from teaser
rates to distress levels. It is more difficult to borrow in today's
market. The economy has reached its debt limit and is entering its
We are not in a cycle but the end of an era. The old world of debt
pyramiding to a fraudulent degree cannot be restored, even if the
Glass-Steagall Act is not restored to stop the conflict of interest
that it unleashed when the Clinton Administration backed Treasury
Secretary Robert Rubin and financial lobbyist Greenspan in repealing
it. The real estate bubble was made possible by the unique degree to
which America's fact population emerged from World War II relatively
debt free. Each recovery has taken off from a higher debt level. This
something like trying to drive a car with the brakes pressed tighter
and tighter to the floor each time there is a stoplight (recession).
We have now reached the debt limit, and the economy is stuck. The
class war is back in business, with a vengeance. Instead of it being
the familiar old class war between industrial employers and their work
force, it is more the old pre-industrial class war of creditors
versus debtors. Its guiding principle is "Big Fish to Eat Little
Fish," mainly by the debt dynamic that crowds out the promised
economy of free choice.
This is being portrayed as a post-industrial economy, but it is a
much older story. No economy in history ever has been able to pay off
its debts. That is the essence of the "magic of compound
interest." Debts grow inexorably, making creditors rich but
impoverishing the economy in the process, thereby destroying its
ability to pay. Recognizing this financial dynamic most economies have
chosen the logical response. From Sumer in the third millennium BC and
Babylonia the second millennium through Greece and Rome in the first
millennium BC, and then from feudal Europe to the Inter-Ally war debts
and reparations tangle that wrecked international finance after World
War I, the response has been to bring debts back within the ability to
This can be done only by wiping out debts that cannot be paid. The
alternative is debt peonage. Throughout most of history, countries
have found again and again that bankruptcy - wiping out the debts - is
the way to free economies. The idea is to free them from a situation
where the economic surplus is diverted away from new tangible
investment to pay bankers for the monopoly they alone have been given
to create bank-credit and charge interest on it. That is the classical
idea of free markets.
Bad debts that are not publicly insured (except by an "implicit"
guarantee that they have bought the relevant Congressional committee
heads body and soul) are to be replaced with new debts, and new
suckers are to be left holding the bag. Bahrainis and Saudis in
particular are being courted.
But most of all, there is a public campaign being waged by the FIRE
sector (finance, insurance and real estate) to convince the American
public that, in the infamous words of Margaret Thatcher, "there
is no alternative." (See for instance the
Wall Street Journal's excellent coverage of the FNMA/mortgage
crisis on July 11, 2002, p. A12.) When one hears this, it means that
political censorship is being mobilized to flood the popular media
with the intellectual equivalent of sterile fruit flies being release
to stop the spread of a threat. All one hears is a barrage of claims
that the government must preserve the financial fictions of FNMA and
Freddie Mac in order to "save the market."
But just what is "the market" that is to be "saved"?
To Wall Street and its Congressional advocates, it is the mass of bad
debts growing at compound "magic" rates of interest, beyond
the ability of debtors to pay. If the debtors cannot pay, then the
Government - "taxpayers" are to pick up the check to Wall
Street. Meanwhile, more tax breaks are to be given to leave the
finance, insurance and real estate sectors with enough money to "earn
back" their losses, by extracting yet more rent and interest from
the industrial economy's consumers and wage-earners.
The usual hypocrisy is being brought to bear claiming that all this
is necessary to "save the middle class," even as what is
being saved are its debts, not its assets. Something must give - and
the upper 10 percent of the population wants to make sure that it is
not its economic position, but that of the bottom 90 percent. The "way
of life" that is being saved is not that of home ownership, it is
that of debt peonage to support an unprecedented concentration of
wealth at the top of the economic pyramid. Debts are to be honored,
although shareholders of FNMA and Freddie Mac probably will be wiped
out, as were S&L shareholders in the bailout of S&L depositors
in the 1980s.
My modest proposal
There's a simple way to save FNMA's and Freddie's public functions,
should they indeed be deemed necessary to keep supporting the mortgage
debt market. This can be done
without bailing out the speculators who bought the junk
mortgages it packaged.
First of all, not all the mortgages that these two agencies have
bought or guaranteed are fraudulent. Most are genuine and are being
paid. The poor are honest, after all, and think that they should pay
as a matter of honor even if it is not in their economic interest to
do so when they fall into negative equity territory. Let these
mortgages continue to back the existing FNMA and Freddie Mac bonds to
the degree that "the market" will support. To the extent
that there is a shortfall, let bondholders take a haircut. It will be
proportional to the degree of financial and real estate fraud they
have enabled. This is the law for all other bondholders. Why make an
exception in the present case?
To keep these activities current, let Fannie and Freddie issue a new
series of bonds. These will come to be known as the "we won't
fake it anymore" series. They would be based on a new honesty,
more honest appraisals of the affordability of housing that they were
supposed to be promoting all along.
These steps would not cause widespread collapse. But before actually
stepping up to save FNMA and Freddie Mac, we should ask whether it
would really be a tragedy if their debt functions were to cease. Their
role has been to extend the market for mortgage debt, creating
opportunities to make money financially in an environment of
asset-price inflation - the Bubble Economy. Prior to FNMA and Freddie
Mac, banks that issued mortgages held onto them, because there were no
outside blind buyers. This was the pre-fraud era. It is now looking
like a Golden Age. Housing prices were lower, and buyers did not have
to go so deeply into debt to purchase homes.
Banks have given politicians a cover story that to support FNMA and
Freddie on the pretense that its packaging and reselling mortgages in
big "tranches" provides liquidity. Its defenders
claimed to be "modernizing" the real estate mortgage market
by creating uniform standards and homogeneous packages. But what was
increasingly tainted with junk, putting floor sweepings of ARMs with
no-down-payment and NINJA (no income, no job) loans into financial
What Fannie and Freddie did was to provide a vast new source of
demand for mortgages. The effect was to push up housing prices. This
has been the great American game for a century. And it has turned
increasingly to outside investors (including gullible German banks
which were the first to go bust by trusting the U.S. junk mortgage
market), swelling the supply of loanable funds that bid up property
The government is now urging the FHA and other government agencies to
prop up the mortgage market by issuing zero-down-payment loans and
other subsidies. The aim is not to help homeowners - indeed, they will
have to pay more if the housing market re-inflates. (Each new economic
crisis adds a few new words to the English language. This one is "reflate."
Others include NYU Prof. Roubini's "stagdeflation" for a
combination of debt deflation of incomes and price inflation for
commodities as the dollar sinks in response to the balance-of-payments
deficit resulting largely from the war in Iraq. But that is another
story. Today's story is all about how Congress is aiming to bail out
the banks that have bought or packaged these junk mortgages; and how
needless this bailout is, how much simpler and more fair simply to
write off the bad debts.
America's $13 trillion in domestic real estate debt is no more
payable than is the government's $3.5 billion dollar debt to foreign
central banks, or the public debt itself for that matter. Adam Smith
remarked over two centuries ago that no government ever had repaid its
debts. At that time the aristocracy - the heirs of the Viking warlords
who conquered Britain and other European countries and turned their
common lands into private property - held most of the land free and
clear. Today, real estate has been "democratized," but this
has been done on credit. Mortgages are the major debts of most
American families. In this role, real estate debt has become the basis
for the commercial banking system, and hence the basis for the
wealthiest 10 percent of the population who hold the bottom 90 percent
in debt. That is what Fannie Mae, Freddie Mac and "the market"
is all about.
Neither party in Congress supports a new bankruptcy bill. The
lobbying money simply isn't there. So the preferred alternative seems
to a new real estate bubble, which means more debt peonage for new
home buyers rather than housing falling back to more affordable
Of course, there is another alternative (TIAA). It is to change the
tax system so as to collect rent as the basis for taxation, not for an
expansion of debt to the banks. Real estate could free labor and
industry from having to pay taxes. Instead, un-taxing property has
forced labor to bear the tax burden, and to pay an equivalent sum in
interest to the banks as well.
But that is a topic for a future article.