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July 15, 2008

The optimistic view that the worst is over in the global financial crisis is undercut by the need for the US mortgage giants Fannie Ma and Freddie Mac to be bailed out by the US Treasury. They are private companies with an implicit government guarantee in a free market economy (that's socialism for Wall Street) and they have been reporting losses all year.

Paul Krugman says that Fannie and Freddie are:

government-sponsored enterprises” established by federal law, which means that they receive special privileges. The most important of these privileges is implicit: it’s the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue. 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.

As their role in the housing market is a stablising one their prospects are central to an overall market recovery since private capital fled the mortgage loan market. Fannie and Freddie are effectively insolvent and are essentially un­able to raise capital without government help. The US Treasury’s plan is to bolster the two mortgage giants with extra liquidity and the pledge to buy a stake if needed.What else could they do? Fannie and Freddie are to big to let them go bust. So much for the faith in market fundamentalism that lets entrepreneurs succeed or fail on their own with regulation seen as heresy.

This scenario, coupled with the collapse of the California-based mortgage lender IndyMac Bancorp, indicates that a number of regional banks in the US are at risk because of their heavy exposure to real estate lending. The value of their stocks plunged. Wall Street's free market rhetoric, in the face of stress the financial system is under, has changed to one of bail us out, bail us out!” To hell with moral hazard.

Wall Street heroically maintains that this is not socialism for Wall Street. It does not distort to the efficient functioning of markets, they say. That is said without a hint of irony, even though on Wall Street's own terms, it is socialism for the rich and the well connected.

There is more stress to come in the mortgage market as the value of the McMansions continues to decline. and householder insolvency increases. Nouriel Roubini says that

these MacMansions and the broader sprawl of suburbian/exurban housing are now worth much less... not only because of the housing bust and the fall in home prices but also because: a) the high oil and energy prices makes it outrageously expensive to heat those excessively big homes; b) households living in suburbian and exurban homes that are far from centers of work, business and production that are not served by public transportation are burdened with transportation costs that are becoming unsustainable given the high price of gasoline. So on top of the housing bust that will reduce home values by an average of 30% relative to peak high oil/energy prices make the same large homes in the far boonies of suburbia/exurbia worth even less – probably another 10% down – because of the cost of heating palatial MacMansions and because of the cost of traveling dozens of miles to get to work in gas guzzling SUVs. Thus, it is time to stop this destruction of national income and wealth that a cockamamie decades long policy of subsidizing the accumulation of wasteful and unproductive housing capital has caused.

Will this kind of subsidy---in the form of tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures---continue? Or will it be wound back as the financial system is slowly reconfigured through crisis management?

In a booming Australia house prices are falling and the reason there are cheaper houses is that fewer people can afford to buy them because credit is becoming so expensive.The fall in house prices is likely to continue partly because prices became extraordinarily high and partly because credit to the market has dried up. That means it is more difficult for households to extract the equity in their houses and it also brings down housing-related economic activity – eg., the construction and improvement of houses, the purchase of durables by households, and the activity of selling by the real estate industry.

| Posted by Gary Sauer-Thompson at 8:06 AM | | Comments (8)


A few years ago in Australia I remember reading solemn articles explaining why the huge increases in property prices were really different this time around. They were not the result of speculation, no sir, they were sustainable indefinitely because they reflected genuinely new underlying circumstances ... new paradigm ... revolution in investment thinking ... don't expect a correction cos there won't be one this time ... blah blah blah.

Will the guilty parties have the grace to admit how wrong they were? What a silly question.

house prices are falling around Victor Harbor, despite the seachange movement and the desire for people to have their dream home on the beach.

They are also falling around Goolwa as the River Murray continues to dry up and the Lakes become muddy ponds.

The real estate industry is spinning furiously, trying to talk things up and avoiding all talk of climate change.

Jim Kunstler ( is pretty bleak about this.

Kunster is bleak.

And so he should be. Wall Street caused the financial crisis with its financial innovations (collaterised debt obligations[CDO's], interest rate swaps, and other bundles of securities).The Central bankers are at fault because their fostered cheap credit and regulatory and prudential supervisory systems were lax, as they did not cover the CDO's. So there was excessive risk taking by unregulated lenders during a housing bubble.

There is carnage on Wall Street according to the AFR. There is blood everywhere as the paranoia about the health of the US banking sector deepens. George Bush is saying the good times are just around the corner, but is anyone listening?

Maybe the market volatility is being fueled by false rumors of runs on the bank put out hedge funds trying to manipulate share prices? Creating opportunities for short term investors.

I love the way Wall Street works. Yep, its all the government's fault cos they cut interest rates too low, held them there for too long, and raised them too slowly.

The AFR makes for interesting reading over morning coffee these days.

Indeed, Peter. I've been reading his stuff with grim relish for a couple of years now.

The hippies were right all along.

I have a question for you AFR readers. If Kunster is correct, what is in store for us in Oz?

Kunster is talking about the US, where its economy is suffering from inflation and recession and its financial system is in crisis. GM Motors in the US is short of cash and facing bankruptcy as a result of the slowing economy and soaring fuel prices. As its fleet is heavy on fuel-guzzling four wheel drives and trucks, it has difficulty in attracting new customers.

The Australian economy is going through a boom; our banking sector is not as exposed to CDO's as the US banks; and the fall in house prices is more gentle and limited than in the US.

The party in the US has ended. Ours is still continuing and it looks as if the upheaval in the US (an economic storm?) is having minimal effect in Australia---though not Europe.

The recession in the US does have global effects--the US consumer is buying less television sets and other goods from China, and though the Chinese are curtailing their orders of machinery from Germany, they are not reducing their demand for minerals from Australia. Will they? No one knows yet.The big mineral companies say the Chinese demand is strong and they could sell more.

A core problem in China is power. 80 per cent of its electricity market is supplied by coal-fired power stations and its domestic coal-mining industry is becoming increasingly high cost. The soaring coal prices and government-set electricity tariffs is forcing dozens of small power plants to shut down rather than face mounting losses.

Their long term solution is to go nuclear.