Global Economic Crisis

It was the night before Christmas, when normally nothing newsworthy stirs. Like a thief in the night, that was the moment selected with precision by U.S. Treasury Secretary Timothy Geithner to stealthily announce a radical policy shift regarding the two bankrupt Government Sponsored Entities (GSEs), Fannie Mae and Freddie Mac. When both of these mortgage giants teetered on the edge of  insolvency in September 2008, they were placed under the largesse of the federal government and the overburdened American taxpayer. In the early days of the Obama administration, $400 billion was established as the maximum guarantee the Treasury Department would provide to these two GSEs to ensure their survival. It was highly unlikely that anything close to $400 billion would be the ultimate cost to the American taxpayer, so assured the Treasury Department. But amid the reassuring rhetoric, something very peculiar is obviously being hatched by Geithner and Company.

On Christmas Eve, one of the quietest news days of the year, the U.S Treasury announced that in lieu of the previous $400 billion backstop, the U.S. taxpayers will now provide unlimited financial support to ensure the survival and liquidity of Fannie Mae and Freddie Mac for the next 3 years. Apparently, by slipping in this policy change near year end, no new legislation is required from Congress. Which is just as well, since it is unlikely that such an unfathomable level of bailout support would be approved by Congress during a mid-term election year.

The real question is this: if, as Treasury originally claimed, a $400 billion guarantee was more than sufficient for these two GSEs, why sneak in a new taxpayer commitment, with no limits?  Speculation is rife, and being fed by the total lack of transparency on the part of Timothy Geithner and his minions. However, this much is clear: Fannie Mae and Freddie Mac collectively underwrite or guarantee half of all the residential mortgages in the United States. If the U.S. Treasury is privy to data on emerging trends on mortgage defaults and residential real estate deflation, there must be something Geithner and his team are cognizant of that they are too frightened to share with the American public, and are spooked to a level that requires such a surreal form of taxpayer guarantee.

With more than $5 trillion of mortgages sitting on the balance sheets of these two GSEs, a new wave of bad real estate news could conceivably  witness the American public assume responsibility for another trillion dollars in bad debts, without a single vote by Congress. There is much more to this story than meets the eye, and the policymakers at U.S. Treasury desperately want to keep the full picture as to why they enacted such a massive overdose of moral hazard in the dark of night under wraps. But a Christmas Eve news dump only obfuscates reality, as opposed to making it disappear. Red lights and shrill klaxons must be going off at Treasury. As with much else involving the global economic and financial crisis, however, the public will be the last to be enlightened when the  rationale underlying the decision to guarantee all the financial obligations  of Fannie Mae and Freddie Mac to infinity can no longer be suppressed.

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Treasury departments and central banks far and near assured their publics that this speedy borrowing spree by the decision-makers had rescued the world’s financial system, thus serving the interests of the now heavily-leveraged taxpayer. Now, only three months later, it is clear that at a terrible financial cost, at most a short respite was purchased. The temporary lull in the LIBOR rate cannot, however, camouflage the essential truth; the major banks and financial institutions in many major economies, particularly in the United States and United Kingdom, are for all practical purposes insolvent.

A banking system that is insolvent is dysfunctional in the extreme. That is the core of the credit crunch that has now precipitated a Global Economic Crisis so egregiously destructive, it will likely exceed the Great Depression of the 1930s in its impact. This is why all the costly deficit spending on economic stimulus packages being enacted in the G7, BRIC and eurozone countries are doomed to failure. The key decision makers are aware of this conundrum, which is why they are frantically searching for a solution to the banking disaster that has frozen normal credit flows throughout the global economy.

The new U.S. Treasury Secretary, Timothy Geithner, postponed his speech on how the Obama administration intended to resolve the banking and credit crisis by 24 hours. Whatever solution he ultimately proposes it will probably, like TARP before it, be insufficient and require further interventions by the Treasury Department and the U.S. taxpayer. Indeed, dark clouds are obscuring an horrific reality; the American banking sector is insolvent to such an immense degree, it would in all likelihood require recapitalization at a level counted not in hundreds of billions, but rather trillions of dollars.

The paradox is that the U.S. economy, as with any other, cannot function without a solvent banking sector. At the same time, it cannot afford the cost of salvaging its banks. Consider what Professor Nouriel Roubini said in a recent interview with the Financial Times: “In many countries the banks may be too big to fail but also too big to save, as the fiscal/financial resources of the sovereign may not be large enough to rescue such large insolvencies in the financial system.”

Thus, the United States created a banking system with large institutions that are too big to fail, due to the systemic risk such a collapse would impose on the national and even global economy. It compounded this roll of the dice by removing any coherent regulatory regimes, instead trusting in the “self-correcting” character of the unregulated marketplace, which encouraged risky behaviors, otherwise known as “innovation,” leading to the creation of unsustainable asset bubbles.

Geithner may try to sugar-coat what in effect will be a TARP II, knowing that the public and its congressional representatives will be reluctant to mortgage the financial future of their children for the sake of another bank bailout. However, no matter how the Obama administration packages its own TARP II bank rescue effort, it is increasingly likely that the foreign credit markets the United States relies on for financing its grandiose deficit spending will simply lack the capacity to loan all the money needed to recapitalize America’s banks.

In the event the credit markets are unable to finance the rescue of the U.S. banking sector, then the lender of last resort will undoubtedly be the Federal Reserve. By resorting to quantitative easing, the Fed may purchase Treasury bills with bank notes it simply generates off of its printing press. In essence this is legal counterfeiting, conjuring up fiat money out of thin air. It may lead to the recapitalization of the banks, on paper. But the net cost will be the destruction of the U.S. dollar as the world’s reserve currency, along with the displacement of the current trend of deflation with a virulent and potentially uncontrollable outbreak of hyperinflation.

The bank rescue mission the U.S. Treasury Department and the Fed are currently embarked upon reminds me of what a U.S. Army spokesman once told journalists during the Vietnam War: “We had to destroy the village in order to save it.”

I fear that this same reasoning may be at work among the policy-makers in Washington, through the enactment of decisions that will destroy what remains of the U.S. economy in order to bailout the “too big to fail banks.” In this instance, however, it is not a village, but the whole global economy that hangs precariously in the balance.

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