Fannie Mae and Freddie Mac, twin pillars of U.S. housing finance, have been plunged into crisis. Only three months after the meltdown and bailout of Bear Stearns, the U.S. Treasury and the Federal Reserve have once again been forced to intervene with emergency measures to forestall a potential crash in the global finance system.

Both U.S. banks and foreign investors, including central banks, hold billions of dollars of mortgage-backed securities issued or guaranteed by Fannie Mae and Freddie Mac (the official acronyms for the Federal National Mortgage Association, set up in 1938, and the Federal Home Loan Mortgage Corporation, set up in 1970). A collapse in the value of these securities, totaling around $5 trillion, would have disastrous consequences for the world capitalist economy.

The Fannie/Freddie debacle is a further, ominous twist in the crisis of the core banking system. This development contradicts the recent, optimistic claim of the IMF that the credit crunch is easing and that world economic growth is about to recover. The credit crunch is far from over and the U.S. housing crisis is deepening. Mortgage lending from commercial banks has almost dried up. Fannie/Freddie now hold almost half of the total $12 trillion U.S. mortgages and are currently financing between 60% to 80% of new mortgages for family homes.

This has given rise to fears among investors that the two quasi-public or pseudo-private institutions are, despite implicit government backing, over-extended in relation to their relatively small capital base. In March this year, Fannie and Freddie had a capital base of $81 billion against loans and loan guarantees of $5.3 trillion.

Such fears have been intensified by the rising number of defaults in the prime mortgage sector in which Fannie and Freddie operate. As in the subprime crisis, an avalanche of defaults and foreclosures could trigger a collapse in the value of mortgage-backed securities guaranteed by the two institutions. Without adequate capital reserves, these giant lenders could become insolvent, with cascading repercussions throughout the system.

As with the Bear Stearns crisis, the Fannie/Freddie crisis is a devastating blow to U.S. capitalism and the prestige of the free-market economy. One headline in the International Herald Tribune (14 July) read: “U.S. Lending Crisis Creates New Reality – Government belief in market’s power replaced by drive to salvage economy.”

One journalist summed up the despair of many commentators in the big-business press: “It’s dispiriting indeed to watch the U.S. financial system, supposedly the envy of the world, being taken to its knees. But that’s the show we’re watching, brought to you by somnambulant regulators, greedy bank executives and incompetent corporate directors. This wasn’t the way the ‘ownership society’ was supposed to work.” (Gretchen Morgenson, The Mortgage Lender Illusion, International Herald Tribune, 13 July)

As with Bear Stearns, the state has been forced to step in, effectively promising unlimited funds to prevent the collapse of these key financial institutions. This case, however, which is inextricably linked to the U.S. housing situation, is more problematic than Bear Stearns.

The state bailout of Fannie and Freddie, like the state-sponsored rescue of Bear Stearns, is a major reversal of the neo-liberal approach adopted by the U.S. and other capitalist governments during the last thirty years of intensified globalization. Faced with the prospect of a catastrophic collapse of the financial system, which would undoubtedly provoke a deep slump in the real economy, even the ultra-free-market fundamentalist Bush regime has been compelled to intervene – in the broader interest of preserving capitalism. This confirms the theoretical prognosis of the CWI, made at the height of the globalization phase in the 1990s, that neo-liberal trends would eventually reach their limits and begin to be reversed. This is the process now beginning to unfold. Moreover, the evaporation of the ‘magic of the market’ will lead over the next few years to a profound political reaction against crisis-ridden capitalism.

What triggered Fannie and Freddie’s fall?
The crisis was triggered by a report that Fannie and Freddie might need an additional $75 billion capital to strengthen their reserves to cushion them against potential losses on housing loans. The proclamation of Treasury secretary Henry Paulson that there was “no problem” failed to avert the debacle. Fannie and Freddie shareholders feared that they would lose out, like Bear Stearns shareholders before them. If the government purchased newly issued shares, it would dilute the value of existing shares. If the government were to go further, and effectively take over the running of the two institutions, the existing shareholders could lose everything. Not surprisingly, then, there was a mass sell-off, including by big financial institutions holding substantial blocks of Fannie/Freddie shares.

On Friday 11 July, Fannie shares dropped 45% and Freddie shares dropped 47% (bringing the fall from peak prices last year to 88% and 85% respectively). Wall Street financiers and overseas central banks warned the U.S. government that the collapse of the share prices could trigger a panic sell-off of mortgage-backed securities issued or guaranteed by Fannie and Freddie.
As with the Bear Stearns crisis, Paulson, Ben Bernanke (Chair of the Federal Reserve) and other Treasury and Federal Reserve officials, together with Fannie and Freddie executives, spent the weekend trying to work out an emergency rescue package.

On Sunday, 13 July, before the Asian markets reopened Monday morning, Paulson announced that the U.S. government would provide whatever backing was necessary to stabilize Fannie and Freddie. Paulson would seek congressional authority to make new loans available and also for the government to buy shares in Fannie and Freddie. At the same time, the Federal Reserve would immediately allow the two institutions to borrow money on the same terms as commercial banks, investment banks and primary bond traders.

These guarantees made explicit the implicit guarantee of support that most investors had always assumed existed. The measures announced by Paulson amount, in effect, to a massive, open-ended commitment by the U.S. government to underwrite these troubled institutions.

The promises appeared to work. On Monday, 14 July, Fannie Mae was able to successfully auction $3 billion of short-term debt. Now that they were guaranteed by the U.S. government, there was a scramble by investors to buy these ‘safe’ mortgage bonds.

The stop-gap measures proposed by Paulson, however, will not provide a long-term solution (even if they are approved by Congress). Stabilizing Fannie and Freddie may not, in itself, be such a difficult task. They both have huge portfolios of loans and, together with additional capital from the government, they could use the income from these mortgages (around $10 billion a month) to cover any losses that arise in the coming months. But retrenchment on such lines would drastically reduce the flow of mortgage finance into the housing market, exacerbating the already profound crisis.

The role of Fannie and Freddie
Historically, the role of Fannie Mae (set up in the New Deal period) and Freddie Mac (set up more recently) has been to keep money flowing to mortgage lenders to expand home ownership. They do this by buying mortgages from the original lenders and packaging them into securities for sale to other investors, guaranteeing to pay the investors if the borrowers default. This leaves the primary lenders free to sell more mortgages.

Their success arose from their peculiar, hybrid status as ‘government-sponsored enterprises’ (GSEs). Because they were seen as having the implicit backing of the U.S. government, Fannie and Freddie were able to raise capital cheaply. At the same time, they are legally owned by private shareholders, who (together with the top executives) have made huge profits from their operations.
Free-market fundamentalists have long complained about the privileged position of Fannie and Freddie. Government backing, they say, gave them an unfair advantage in credit markets. They were subject to minimal regulation compared with commercial banks. And they benefited from low federal and state taxes.

During the Clinton presidency, the Treasury department tried to rein in Fannie and Freddie. However, the two institutions successfully fought off the attempts to impose tighter regulation and an increase in capital reserve requirements. They intensively lobbied Congress. Huge amounts of cash were channeled into the campaign funds of key committee members. In 2006, Freddie Mac was fined $3.8 million for violating election laws. At the same time, there was an accountancy scandal in Fannie Mae, which was found to have inflated profits by $6.3 billion in order to push up executives’ bonuses.

The Wall Street Journal sums it up quite well: “The Washington political class has nurtured and subsidized these financial beasts for decades in return for their campaign cash and lobbying support. Wall Street and the home builders also cashed in on the subsidized business, and also paid back Congress in cash and carry.” (Editorial, Fannie Mae Ugly, 14 July) But many big-business politicians, both Democrats and Republicans, defended Fannie and Freddie on the grounds that they expanded the supply of relatively cheap mortgages to ‘middle-class’ families. Moves against the twin pillars of housing finance would not win votes.

Today, the free-market ideologues are full of contempt for the government-sponsored enterprises. Now they are disowning Fannie and Freddie as illegitimate ‘socialist’ institutions, a blemish on true free-market capitalism. But, as one commentator points out, this is an ironic turn of events. Fannie and Freddie provided the model for the exotic financial instruments that were recklessly developed by the ultra-free-market speculators of recent years.

“Fannie and Freddie were the inventors of the mortgage-backed security, a principal cause of the housing bubble and its subsequent deflation. They won plaudits for it: for years, the unbundling and reselling of mortgages was deemed a good thing, the secret of the U.S. market’s success.” (Clive Crook, Guarantees for America’s Guarantors, Financial Times, 13 July) Fannie and Freddie played their part in blowing up the unprecedented housing bubble of recent years.

Moreover, the investment banks make huge profits from the fees they get from selling Fannie and Freddie mortgage debt and securities: $953 million in 2007 and $550 million so far this year.

The U.S. government’s dilemma
The hybrid character of Fannie and Freddie – pseudo-private, quasi-public – creates a huge dilemma for the U.S. government and big business generally. However much they may dislike the set-up, they are forced to rescue these massive institutions, which are ‘too big to fail’. When he announced the rescue plans, Paulson stressed that his “primary focus is supporting Fannie Mae and Freddie Mac in their current form,” that is as shareholder-owned companies. Paulson was “not talking about nationalization”.

Nevertheless, however distasteful it might be to the advocates of free-market capitalism, massive government intervention may well end in de facto nationalization. If the government pumps money in through buying newly issued Fannie Mae and Freddie Mac shares, the existing shareholders will lose out through the dilution of their existing shares. If the government injects capital through massive government loans (effectively subsidies, as with Bear Stearns) the federal government would effectively become the owner – and would take over the management of the two bodies. Again, the shareholders would lose out. Editorial writers in the main big-business journals recognize, in reality, that shareholders are ultimately expendable and a rescue is likely to end in government control.

Pseudo-socialism
The Wall Street Journal, for instance, called on the government to strengthen the capital base of Fannie and Freddie: “Treasury and Congress [should] step up now with a public capital injection to help the companies ride out their losses.” The government should buy shares in the companies so that taxpayers will get a return once the crisis is over.

“We haven’t suddenly become socialists. What the U.S. taxpayers need to understand is that Fannie and Freddie already practice socialism, albeit of a dishonest kind. Their profit is privatized but their risk is socialized. We are proposing a more honest form of socialism, with the prospect of long-term reform.” The mortgage portfolios of Fannie and Freddie, they say, should be reduced and eventually wound up. (Fannie Mae Ugly, Wall Street Journal, 14 July)

The Financial Times takes a similar position, calling for “a decent burial for Fannie Mae”. (Editorial, 14 July) Fannie Mae and Freddie Mac, they argue, “could be broken up into small pieces and privatized. A rump could be retained by the Treasury as a small counter-cyclical mortgage liquidity vehicle [presumably state-subsidized mortgages during a credit crunch]. The process might involve a period of nationalization. This could mean the government-sponsored enterprises’ vast debts would be moved onto the public balance sheet. However, this is unimportant. It would be a cosmetic change; the government is already backing them; it is absurd they are not now on the books.”

In practice, this would mean adding $5 trillion (Fannie and Freddie’s potential liabilities) to the existing federal debt of $9 trillion.

Nationalization – or ‘conservatorship’?
The U.S. government – and Congress, too – will go to any lengths to avoid the impression that they are nationalizing Fannie and Freddie. A de facto state takeover, if it goes that far, will be presented as ‘conservatorship’.

“A plan to take the enterprises over exists,” writes Clive Crook. “Rather than nationalizing them – which would be un-American and could be mistaken for socialism – they would be placed in ‘conservatorship’. It is the same thing, except that it could allow the government to pretend that the GSEs’ liabilities were even then not its own.” (Financial Times, 13 July)

This would be based on the discovery by the regulator that Fannie and Freddie are “critically under-capitalized” and would need to be “adequately capitalized” through government investment. Such a measure, of course, would not be socialist, but an intervention by the state to safeguard wider capitalist interests. But it would demonstrate the contradictions and limits of market forces.
Paulson was hoping to push his proposals through Congress in a few days, giving him authority to pump unspecified and unlimited capital into Fannie and Freddie. Many in Congress, however, both Democrats and Republicans, are unwilling to write Paulson a blank check. It seems likely to take more time for the government to get legislation passed, and it may be more limited than Paulson is seeking.

The emergency measures so far announced by Paulson will only stabilize Fannie and Freddie, they will not in themselves maintain the flow of cash into the mortgage market. “If [the government] wants lots of new loans to be made by the mortgage giants, it may either need to [provide subsidies to Fannie and Freddie] or effectively nationalize them and pump taxpayer money into the mortgage system.” (James Saft, What Next for Fannie and Freddie? International Herald Tribune, 15 July)

Housing crisis deepens
The Fannie/Freddie crisis is a symptom of the deepening housing crisis, with a vicious cycle in the housing market. Since the collapse of the bubble, there is a massive over-supply of housing (in relation to money-backed demand, not social need). Prices are still falling dramatically. Measured by the Case-Shiller index of 20 major cities, prices fell by 18% in nominal and 22% in real terms between their 2006 peak and April this year. Falling prices mean that home-owners cannot afford to refinance their mortgages, and many now have negative equity (their mortgages exceed the current value of their houses).

There are expected to be 2.5 million foreclosures by the end of this year. The sale of repossessed houses is pushing down prices even more. But banks are extremely reluctant to lend, and people are finding it extremely difficult to get loans to buy even at cheaper prices. The housing crisis is far from over. In the first quarter of 2008, Fannie Mae reported that it had allocated $3.2 billion to cover mortgage defaults, a small fraction of its loans, but enough to reinforce fears among investors that its defaults will grow.

Meanwhile, total worldwide subprime losses reported by major banks and financial institutions have now reached $400 billion. Bridgewater Associates recently estimated that total losses could be around $1.6 trillion.

Bank failures
While the Fannie/Freddie drama was unfolding, there was a classic bank run on the Californian bank, IndyMac Bancorp. After reports that the bank was insolvent, depositors drew out $1.3 billion in eleven days. The federal regulator, the Federal Deposit Insurance Corporation (FDIC), was forced to move in and take over the bank. This was the third largest bank failure in U.S. history, and the biggest since the collapse of the savings and loans institutions in the early 1990s.

After the problems of the major investment banks, small local banks are now being battered by the housing crisis and business failures, especially building firms. Bank shares are plunging on the stock exchange as investors sell to cut their losses, and this arouses fear among depositors who think their bank may be about to collapse. While major banks are ‘too big to fail’, many fear that small and medium-sized local banks are ‘too small to bail’.

The FDIC guarantees deposits of up to $100,000. It will need between $4 billion and $8 billion to guarantee the funds of IndyMac depositors, and has reserves of about $53 billion. The FDIC is predicting that between 50 and 150 of the U.S.’s 7,500 insured banks will fail over the next twelve to 18 months. But it could be a lot worse. In the first quarter of 2008, for instance, the FDIC said that there were 90 ‘troubled’ banks – but its list did not include IndyMac Bancorp!

Intensified slowdown of advanced capitalist countries
The U.S. economy continues to slow, almost to a standstill, with unemployment and inflation both rising. Bernanke has warned that the downturn has far from run its course. The IMF, however, has recently issued a more optimistic report (Independent, 18 July) claiming that the effects of the subprime crisis are easing. It has raised its estimate of U.S. growth to 1.3% this year (from 0.5%) and world growth to 4.1% (from 3.7%). Some commentators are encouraged by the fall in the price of oil, but this is mainly due to the fall in demand caused by a slowing of economic growth.

Yet the OECD is warning that the Group of Seven leading industrial economies are about to experience an “intensified” slowdown, as are Brazil and India (Wall Street Journal, 14 July). Figures for May, moreover, show that eurozone industrial production fell by 1.9%, the biggest monthly drop for 16 years. This indicates a significant slowdown in the 15-country region. (Financial Times, 14 July)
This is not a short cyclical downturn in the world capitalist economy but the beginning of a protracted crisis. The Fannie and Freddie debacle is just the latest episode.

Martin Wolf, the Financial Times columnist, was formerly an enthusiastic advocate of globalization and free-market policies. Now he writes: “It is now almost a year since the U.S. subprime crisis went global. Many then hoped that the repricing of risk would be no more than a brief interruption in the progress of the U.S. and world economies. Such hopes have been disappointed. The woes of Fannie Mae and Freddie Mac, the tumbling stock markets and the climbing oil prices make clear how far the turmoil is from its end. It has, in all likelihood, not even passed the end of its beginning.” (A Year of Living Dangerously, 16 July)