Henry Kaufman, aka Dr. Doom for his prominence and prescience in reading the bond markets during the painful early 1980s credit crunch, said not surprisingly that the Federal government needed to assist Fannie and Freddie.
Unfortunately, the more important part of Kaufman’s message is likely to be ignored. The former Salomon Brothers chief economist also urged Washington to step up the pace on regulatory reform, starting with the formation of a bi-partisan committee.
Unfortunately, this Administration doesn’t know the meaning of the word “bi-partisan.” And even though market participants know that an unmanaged crisis at the GSEs has the potential to End the World of Finance As We Know It, it probably will not focus the mind of legislators enough to get them to roll up their sleeves and take the problem seriously.
Readers like to pooh pooh the ability of Congress to contribute here. However, the securities law reforms on the 1930s came after a period of lax government and considerable corruption in the nation’s capital. But it took a collapse of the banking system to galvanize the needed response. Do we really need to repeat this history?
The U.S. government needs to intervene to save Fannie Mae and Freddie Mac and then overhaul fragmented regulation of financial institutions and markets, according to comments Friday by economist Henry Kaufman, who rose to Wall Street prominence spotting previous credit crises.
The investment manager and former Salomon Brothers executive said that the U.S. Treasury Department should be ready to offer finance to the floundering mortgage giants and encourage the two agencies to draw on their contingency lines of credit with the government.
The Treasury “should also state that, if needed, it would be willing to supply new equity capital to these agencies through the issuance of preferred stocks,” said Kaufman, …
Kaufman, who once was known as “Dr. Doom” for his accurate forecast that the Federal Reserve would drive up interest rates to more than 20% in the 1980s, also called for the creation of a bipartisan commission to develop recommendations on an overhaul of “our fragmented supervisory and regulatory system.”
He added that current efforts to improve oversight of the country’s financial institutions lacks direction and is moving too slowly. “This commission should render a report by no later than October, and Congress should consider legislation even before a new president takes office. The urgency is too great and markets will not wait.”.
For skeptics, Dwight Cass at BreakingViews gives an idea of what a GSE doomsday scenario would look like:
The government-sponsored entities’ woes cause the value of their trillions of dollars of outstanding debt to plunge. Banks stuffed full of this paper face huge losses, which some can’t survive. They and other investors, such as foreign central banks, dump it.
Fannie and Freddie end up unable to lend, at least at their current pace, further punishing the reeling housing market. This causes more problems for banks and investors, making credit scarcer.
Of course, that all would take a truly incompetent response to a crisis that has been foreseeable for a year or more. But given US lawmakers’ belief that the GSEs are tools for their political ends, it’s not entirely out of the question.
That’s only the domestic part of the equation. A Fannie and Freddie crisis has the potential to trigger a dollar crisis, pushing already high commodity prices through the roof.
I have said repeatedly that the US is in the same position as Thailand and Indonesia circa 1997, except we have the reserve currency and nukes. It isn’t obvious how we avert a crisis. From a VoxEu summary of research on financial crises by Carmine Reinhart and Kenneth Rogofff:
Another regularity found in the literature on modern financial crises is that countries experiencing large capital inflows are at high risk of having a debt crisis. Default is likely to be accompanied by a currency crash and a spurt of inflation.
Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.
Note that China is also experiencing large capital inflows despite having large trade surpluses.