Implications of Federal Government’s decision to bail out Fannie Mae and Freddie Mac aren’t known yet

In my March column, I suggested that the government might be forced to nationalize Fannie Mae and Freddie Mac as a last resort to solve the credit market problems. Both President Bush and Secretary of the Treasury Paulson said they would not be bailing out the mortgage market. By August, Paulson was asking Congress for a “bazooka” to deal with the problem. Apparently his trigger finger developed an itch.

On Sept. 8, just days after mortgage delinquencies and foreclosures surged to the highest levels in history, the Federal Government, acting through the Treasury Department, and with the Federal Reserve acting in “a consultative role,” did, in effect, nationalize the Government-Sponsored Entities Fannie Mae and Freddie Mac. Saying that it was not nationalization, the government seized control of the two GSEs, and transferred control of both to the Federal Housing Finance Agency. It has been given the power to expand the two companies’ mortgage portfolios by $100 billion each to a maximum of $850 billion by the end of 2009. The portfolios will shrink after that.

Presently, not all the terms of the transaction are clear, and the implications are yet to unfold, but it can be expected that American taxpayers will eventually be presented with a large bill. Much ink will be spilled in coming days over the morality of this transaction, the morality of doing it and the morality of not doing it. Nevertheless, the Treasury found itself in the position of having to act or watch a disaster of epic proportions unfold. The prospect of more write-offs for banks, and havoc in the international credit markets was too much to […]

More time and work needed for American economy to recover from present woes

In the past I have written in this column that it was going to take time and work to solve our present economic problems. We are in the midst of that process now. Still more time and work are needed.

After a slow start the Federal Reserve has found new energy, with some exceptions like their May and June exhortations regarding inflation that spooked the markets. Then it of course had to bail out Fannie Mae and Freddie Mac before the housing roof fell in. At its July meeting the Fed moved the prospect of rising interest rates further into the future, and managed to offend nearly everyone. At its recent August meeting, the Fed seemed to push interest rate increases even further into the future.

In the meantime, Congress and the Executive branch offered up a “stimulus” package that was swamped by the continuing high price of oil and falling house prices, and barely caused a ripple. Now both branches are back with a housing package that will have little impact.

As I said before, we cannot mount a recovery until the housing crisis is solved. The markets seem to understand this fact even if the deep thinkers in Washington and bank boardrooms do not. […]

Following a 10-percent drop in June, the overall markets have entered bear territory. The numbers were the worst for the month of June since the Great Depression. Because they’re a leading indicator of the economy’s standing, a bear market usually signals further erosion. With the economy already under stress due to housing and credit market issues, any more erosion could be serious.

Even worse, it was believed for a while that the global economy would be better and subsequently buoy the U.S. economy; however, signs now seem to point to a global slowing. After a big run-up last year, stocks in Shanghai were down 21 percent for the quarter. For the year, Shanghai is down 48 percent, and now at 16-month lows. Year to date, India is down 33 percent, while London, Frankfurt and Paris are down between 13 and 21 percent. Japan recently had 12 straight days of declines. Some analysts now see the market testing 2002 lows, which would imply further sharp declines in the averages.

Housing and credit market problems are further heightened by high oil prices, a weak dollar and the threat of inflation. Indeed, Fed speakers have talked a lot recently, probably too much, about the threat of inflation and the need to raise interest rates. At the last Fed meeting, the policy statement had something to offend everyone; however, the emphasis was on the risk of inflation. Normally under these circumstances one would expect the Fed to raise interest rates, which would have the effect of strengthening the dollar. But because of the fragile economy, the Fed cannot raise rates now. Indeed, in spite of all the Fed talkers, the board seemed to move interest rate increases further into the future, […]

On May 28 I appeared on CNBC and was asked about the declining U.S. dollar. During the interview I said that a strong dollar was in our interest. It didn’t take long for Ben Bernanke, Chairman of the Federal Reserve, to get the message. Last week Mr. Bernanke talked tough to the markets. In an unusual statement, he specifically addressed the weak dollar and put the markets on notice that the next fed interest rate move would be up.

The topic of the dollar’s weakness is usually left to Treasury officials to discuss. It is unusual for any central banker, not just the Chairman of the Federal Reserve, to discuss the level of a currency. Perhaps Bernanke was dissatisfied with the executive branch’s handling of our dollar policy. Perhaps he was dissatisfied with congressional policies that weaken the dollar. Perhaps he too believed that a stronger dollar would lower the price of oil. No doubt he thought a tougher Fed policy and the stronger dollar would slow inflation and be good for the economy as a whole. In the latter, he was correct.

For a long time the price of oil has been trading inversely to the dollar. As the dollar weakens, inflation becomes a more pressing issue for Americans. It has been long commented in this column about the dilemma the Fed faces in assisting a faltering economy while still containing inflation. If the Fed lowers interest rates to aid the housing and credit markets, the dollar will weaken and more inflationary pressures will result. The Fed must act now to halt inflation, before inflationary expectations become the norm and a self-fulfilling prophecy. […]

The stock market got through August with the Dow Jones industrial average up 1.1 percent, but not before a wild, volatile ride, with 14 triple-digit moves in the 23-tradingday month.

The performance easily bested the 12 triple-digit moves of August 2002. This August, the Dow reached a high of 13,600 and plumbed a low of 12,900, but it ended about where it started. Although August has a reputation for being a difficult month, we survived it and now move into September, another historically difficult month.

The reasons for the volatility were, of course, the problems in the housing market and the subprime loan debacle. Lenders re-rated risk, and the price of paper, whether mortgages or commercial paper, was cut.

As the subprime problem spread to other sectors of the mortgage market and then to the commercial paper market, creditworthy borrowers were hurt. Fears of a recession grew. Calls for the Federal Reserve to take action intensified. Housing prices were affected, too. The question was, Will the difficulties in the financial markets spread to the “real economy”?

Seeds for the mortgage problems were sewn years ago, under the Greenspan administration, when interest rates remained at historically low levels for a long period of time. During that time, Greenspan, worried about deflation, and schilling for adjustable-rate mortgages, encouraged home borrowers to “take advantage” of the adjustable rates, marking the first time a Federal Reserve chairman had involved himself in the selling of home loans. Subprime borrowers and homeowners, many of them new, began to take advantage of the low rates. […]