Some Musings About the Nationalization of FNMA and Freddie
September 8, 2008
The immediate reaction of financial markets was understandable in all respects. Near-term prospects for the global financial system look better, and that noise you hear is a collective whew. Stocks have advanced. Bond prices fell. Non-U.S. sovereign bonds and equities followed the U.S. lead. The dollar improved, reminiscent of the catalytic role played by the March rescue of Bear Stearns in stopping a sharply falling dollar and paving the way for a still-going correction.
The decisions on Fannie and Freddie were driven by market pressures and housing market economics, but they are nevertheless politically convenient for the incumbent Republicans, who in the last two weeks already had established a momentum lead in the presidential race. The failure of one or more big U.S. banks in September or October could have been disastrous, especially against the backdrop of the rising unemployment rate, which climbed from 5.0% in April to 6.1% by August.
The United States is not the only economy with a housing depression. It is reasonable to think that U.S. housing prices will not suffer as much additional price loss as they would have if FNMA and Freddie had not been seized by the government. It is not reasonable to think that housing prices will not continue to fall in the short term. It is also not reasonable to expect the nationalization to remedy the housing market problems in other countries like Britain, Spain, Ireland, New Zealand and Australia to name five.
Speaking of Britain, the nationalization of Northern Rock Bank did not help sterling, which has emerged as a major object of speculative bad-mouthing and selling pressure. At least one big hedge fund projects that sterling will depreciate by an additional 20%. Sterling has declined already by some 20% against the euro from a high of 0.6538 on January 23, 2007. It’s weakest quote against the Deutsche mark of 2.164 was printed on November 17, 1995, more than three years after Black Wednesday when another famous hedge fund took on the British government and forced the pound’s withdrawal from the Exchange Rate Mechanism (ERM), a humiliating experience that solidified voter opposition to participating in the euro. The euro translation value of DEM 2.164/GBP is 0.9038, so the euro needs to rise by a further 10.4% just to reattain the D-mark’s historic peak against sterling. Dollar/mark back then (1.4429) was very near to its current synthetic value, but cable was much weaker at $1.4040.
The conventional view holds that U.S. housing prices need to stop falling for an enduring return to a normal expansionary business cycle. While house prices continue falling, it is not clear that the nationalization of the two GSE giants are going to create enough comfort to kick-start the moribund pace of bank lending. The point here is that even the short-term U.S. economic prognosis remains fragile. By the same token, any marginal improvement in sentiment and performance is unlikely to be matched fully, if much, in other economies. On balance this move should be a positive development for the already established uptrend in the dollar.
That vote of confidence is especially true in the cases of dollar/yen and dollar/Swissy, the low-yielding currencies used to finance carry trades. Such investments do best in an environment that tolerates financial market risk. The main potential gain from the Treasury’s nationalizations is the chance to restore some confidence in financial institutions.
Long-term consequences of the GSE nationalizations could be very adverse, markets seldom react persistently to long-term possibilities or even probabilities until those risks move into much closer sight. $5.3 trillion of liabilities is not chump change. If America is lucky, the final bill to taxpayers will be much less than a worst-case scenario as was the case with the savings-and-loans bailout some two decades years ago. Too many unpredictable factors will affect the ultimate cost to make an educated guesstimate at this stage. What worries me is that the Federal deficit had already taken a very big turn for the worse this year. The deficit has done worse with Republican control of the White House, and McCain’s victory chances are looking better each day.
McCain promises to follow orthodox Republican practices in two key directions. He favors more tax cuts, but more important than that, he believes that decisions to go to war or not should be made without regard to their possible fiduciary cost, but rather strictly on what national interest might be at stake and whether military victory is achievable. There’s no place for cost effectiveness when national security is on the line. And as Rudy Giuliani so aptly put with a sports metaphor, “the best defense is a good offense.” That is a recipe for always placing the burden of proof on the side of not going to war, and its flaw gets exposed if one considers what happens in the long term. History shows that military hegemony cannot be sustained if the domestic economic strength withers under the weight of endless foreign military operations. Such doomed previous hegemonies in Classical Greece, 16th century Spain, 19th century France, and 20th century Russia.
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