World stock markets are again reeling, this time on rumors that the two largest financial institutions in the world are technically insolvent. This is the U.S. Government-backed mortgage insurers Fannie Mae and Freddie Mac – described as “the backbone” of the U.S. housing market, and accounting for around half the $12 trillion US mortgage market. Their collapse would represent a financial earthquake, dwarfing previous financial shocks such as the March collapse of Bear Stearns.

And the spectacularly bad news doesn’t stop there. Friday also saw US federal regulators seize control of another lender, IndyMac Bancorp (not related to Fannie Mae and Freddie Mac). The failure of California-based IndyMac is the second biggest bank failure in US history, and the biggest casualty of the financial crisis that began a year ago. IndyMac fell foul of a classical run on the bank – panicked savers withdrew $1.3 billion over the last fortnight. This run was reportedly triggered by the publication of a letter on 26 June written by Senator Charles E. Schumer (Dem) in which he questioned the bank’s viability. Bear Stearns also blamed its collapse on an email sent out by a Goldman Sachs economist. Whatever the truth of this, it does not say much about the strength of these – once so powerful – institutions if they can be reduced to ruins by a letter! IndyMac had $32 billion in assets just three months ago. Its collapse is the biggest in the US for 24 years. Today, there is intense speculation over whether the much bigger Fannie Mae and Freddie Mac will go the same way.

The Federal National Mortgage Association (known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) own or guarantee a combined $5.2 trillion of housing debt. For the purposes of comparison this sum is roughly one-and-half times the size of China’s gross domestic product (GDP), measured in dollars.

The failure of the two companies ”would cause a complete collapse in the mortgage market,” capital manager, Paul Ashworth, told the Financial Times (July 14). ”Even if the authorities are successful in putting out this particular fire, others will no doubt spring up,” he warned.

Government-Sponsored Enterprises (GSE)
A deal was put together by the US Treasury (finance ministry) and Federal Reserve (central bank) late on Sunday 13 July, in a now familiar pattern of eleventh hour weekend rescue operations designed as ‘circuit-breakers’ to stop a panic from Friday’s close of the New York Stock Exchange spreading once Asian bourses open on Monday morning. Stock markets are huge casinos, often influenced by psychological factors – fleeting bouts of pessimism or optimism. The central bankers have to take such sentiment into account, increasingly using the weekend break to try to create a short-lived mood of “confidence” in order to prevent further panic selling of equities and other financial assets. As one commentator said of Sunday’s rescue plan, ”ultimately, the success or failure of this plan rests with the market” [CNN, July 14].

Under this plan, the Federal Reserve will ask Congress for ”unlimited authority” to buy stock in Freddie Mac and/or Fannie Mae if necessary and grant them loans at lower rates previously only available to commercial banks. This is described as a ‘back-stop’ arrangement, whereby extra liquidity can be injected into the two companies ”as needed”. Hence neither firm is formally taken over by the state, as in the case of IndyMac. Prior to this announcement, rumours circulated that one or both of Fannie Mae and Freddie Mac would be brought into ‘conservatorship’ – meaning a full state takeover. Clearly, Treasury Secretary Henry Paulson Jr. and the Bush administration are desperate to avoid this if they can. In March, the Federal Reserve paid the investment bank JP Morgan $30 billion for it to purchase Bear Stearns, and thereby ‘save’ the Fed from the need for a direct takeover. On Fannie Mae and Freddie Mac, Paulson is at pains to stress that the government wants to save them in their “current form” – as so-called government-sponsored enterprises (GSE), which are backed by the state, but listed on the stock exchange and run as private companies.

These companies were created in the 1930s to promote homeownership by buying up or providing guarantees for mortgages sold by private banks. Their peculiar status as “government-sponsored enterprises” emanates from the fact that despite their private ownership, they were established by federal law, and as such enjoy certain privileges. The main privilege is that they are seen as “a safe bet” – i.e. that the government will come to their rescue if they overextend themselves. This idea is now being put to the test.

The economist and leading Bush administration critic, Paul Krugman, explains:
“This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.” [The New York Times, July 14, 2008]

Jitters about the two companies – whose shares plunged 45 percent last week – caused chaos on global stock markets, adding to the sharp falls of the last six weeks. Of the world’s 52 largest stock markets, 49 have declined this year. The New York stock market officially entered a “bear market” last week, which is characterised as a fall of 20 percent or more. China’s market is in that case in “double-bear territory” – with losses exceeding 40 percent so far this year. Only one month ago a sizeable body of capitalist “experts” were telling us the worst of the global crisis was over. Most of these commentators seem to have been shocked into silence by the latest turn of events.

“A Crucial Test”
Sunday’s deal “is a crucial test of US economic policymaking” according to the Wall Street Journal. The newspaper said the Federal government needed “to act fast to cauterize the wound…” meaning that continued fears of a collapse of Fannie Mae and Freddie Mac would deal a shattering blow to the workings of the financial system as a whole.

The same Wall Street Journal article warned: “Here is the doomsday scenario: Falling house prices and non-paying homeowners cause the value of the trillions of dollars in outstanding debt held by these government-sponsored enterprises to plunge. Many banks have balance sheets stuffed full of this paper. They face huge losses, which some can’t survive. They and other investors, such as foreign central banks, then dump the GSE paper [i.e. bonds issues by Freddie Mac and Fannie Mae].”

But even among the capitalist commentators there is a heated debate over the latest bailout. Jim Rogers, a former associate of top speculator George Soros, called the deal an “unmitigated disaster’’. He told Bloomberg News that it, “ruins the Federal Reserve’s balance sheet and it makes the dollar more vulnerable and it increases inflation.’’

This is undeniable. At the same time, what choice does the US capitalist class have? If they failed to act, the entire financial system is threatened, and not just in the US. Already the collapse of IndyMac on Friday has raised concerns about the state of US regional banks, many of which could be in a similar parlous condition. However, even if the latest rescue plan stabilises financial markets temporarily, the underlying problems are no less serious, and the latest plan can further exacerbate the dollar’s fall, which in turn will push up global oil prices and inflation.

Beyond Subprime
What is behind this latest shock to the global capitalist financial system? And what could it mean for ordinary working people in the US and elsewhere? The crisis at Freddie Mac and Fannie Mae is a result of the worst housing slump in the US since the 1930s. This in turn is causing a full-blown recession in US (economists still haggle over whether the recession has formally started yet or not, but most Americans believe it has). From 2006, the market value of the US housing stock is down by about 16 percent. Case-Shiller, who predict housing trends, believe average prices will fall by another 15 percent before the housing market bottoms out in 2010. That will mean a further $3 trillion being wiped from the assets of US households. The cumulative effect of this, alongside rising oil prices, is eating into US consumption, a key determinate of US economic performance. A collapse for Freddie and Fannie would prolong the slump in housing and, by extension, the overall economic downturn in the economy. With the onset of the credit freeze, the two companies have acted as the last ”pillar” preventing a complete collapse of housing market credit.

”This is a very serious financial crisis and it is the most serious financial crisis of our lifetime,” warned George Soros. ”It is inevitable that it is affecting the real economy. It is an idle dream to think that you could have this kind of crisis without the real economy being affected.”

There are more disturbing signs about the crisis facing Freddie Mac and Fannie Mae. These companies did not deal in the high-risk or ‘toxic’ subprime loans that originally triggered the financial crisis last year. Subprime loans are by definition loans that do not meet the more stringent criteria used by Freddie Mac and Fannie Mae when buying or guaranteeing home loans. This flows from their semi-government role whereby they provide a basic regulatory framework for the housing market. There can be no clearer sign that the downturn in the U.S. housing market and wider economy is now spreading far beyond the subprime sector. Economists have produced maps of US cities that show in a graphic form how the housing contagion is now spreading from poorer inner city areas to formerly affluent outer suburbs. Freddie Mac and Fannie Mae have been hit by rising defaults (non-payment of loans) and falling house prices. The two companies have lost more than $11bn in recent months. At the same time the credit crunch, with loans between banks becoming more expensive, has affected their balance sheets. Shares in the two companies have fallen by 80 percent in the last year, as market speculators have shifted out of financial stocks and piled into commodities and other assets seen as less risky. Last week, William Poole, the former president of the St Louis Federal Reserve, said that Freddie Mac was “insolvent”, i.e. its debts were greater than its assets.

Global Effects
To a greater extent than the previous phases of the US banking and housing crisis, this latest development is a potential nightmare for China and other governments that are big holders of US debt. The mortgage-backed bonds sold by Freddie and Fannie have been popular investments for central banks, mostly in Asia, which hold around $979 billion worth.

“According to the U.S. Treasury Department’s latest data, foreigners owned 21.4%, or $1.3 trillion, of the total outstanding long-term debt issued by U.S. government agencies as of June 2007. China and Japan were by far the largest investors in such securities, holding $376 billion and $229 billion, respectively. It isn’t clear how much debt either country owns from Fannie and Freddie specifically.” [Wall Street Journal, July 14, 2008]

Russia’s central bank also holds about $100 billion of this agency debt. If this debt depreciates in value, this will cause particular problems for Japanese banks, which so far have largely avoided big losses from the US subprime crisis. In Japan, it is mostly private banks that have the biggest exposure to US agency debt. This is not the case in China, where the government mainly holds such securities in its foreign-currency reserves. In the latter case, it would mean the Chinese state must take a ‘hit’ i.e. significant losses as the value of its dollar holdings is degraded. Should China’s central bank decide to cut its losses by selling large quantities of this agency debt, especially in today’s panicky market conditions, this could trigger a new crisis and possible collapse of the dollar.

“This is the most dangerous moment,” says Andy Xie, a Hong Kong economist, who subscribes to the view that the latest US government bailout will lead to a further decline in the dollar. This increases the pressure on Asian central banks stuck with massive holdings of dollar-based securities.

For the US economy, and through it the rest of world capitalism, these events can add significantly to the recessionary pressures already at work. The meltdown of Freddie Mac and Fannie Mae can exacerbate the credit crisis and the downturn in the housing sector. That the gloomiest of economic periods lies ahead was spelt out by the Wall Street Journal:

“Politicians will have to accept that more pain is probably in store for the housing market. The GSEs can’t continue to grow at their recent pace; they may need to cut back their activities to give jittery lenders more comfort. That would dampen mortgage lending. The trick will be to do enough to stop the rot now, while spreading the pain out over time – making it chronic, perhaps, but not fatal.”

When these commentators talk about “pain” of course, they mean for the poor majority, not the rich. This choice – between “chronic” or “fatal” conditions – is what the capitalist system has to offer today. And this is in the richest of nations. For the four-fifths of humanity in the ‘developing’ world even more pain, from rising food and fuel prices, is in store. The spectacular ongoing implosion of the US banking sector underlines the urgent need to re-equip the working class internationally with a fighting socialist alternative.