Oscar Wilde once described the British aristocracy’s peculiar predilection for fox hunting as the “Unspeakable in pursuit of the Inedible”. In today’s world, the ruling elites in most countries tend to focus their attention on saving their respective financial sectors, with a view to ensuring systemic stability even as idiosyncratic failures abound (see The New Brahmins, Asia Times Online, March 29, 2008). Much like fox hunting, where scores of hounds and teams of horsemen come back with a mangy fox or two, pickings from financial sector rescues tend to be quite slim.

In the US since the middle of last year, various arms of the financial sector have been progressively trimmed, starting with the exotic structured investment vehicles (SIVs) then moving swiftly on to mortgage servicers and providers, and spiralling merrily on to investment banks. Doubts about various commercial banks that take deposits from the public have also surfaced from time to time. All of these entities, though, are mere intermediaries that originate risk and transfer them to other investors, including overseas investors and more importantly, two large US financial firms that absorb the interest and credit risk of millions of American households.

This week, the final chapter in the unravelling of US systemic leverage opened with salvos on two most important government sponsored entities (GSEs) operating in mortgages, namely Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corp. (Freddie Mac). These two financial behemoths have between them about US$5 trillion of mortgage assets, owned or guaranteed, in effect touching some 70% of all mortgages in the United States.

Even though these companies are sponsored by the US government, they operate as publicly listed stocks. Looking at their combined stock market valuation of less than $20 billion as of Thursday night (July 10) compared with their $5 trillion in assets shows them already to be in significant economic distress. In contrast, US commercial banks such as Citibank, JP Morgan and Bank of America have stock market capitalization of around 10% of their total assets, even after the massive decline in stock prices this year. Of the $5 trillion, roughly $1.6 trillion sits on the balance sheets of the two GSEs, with the rest “off” balance sheet – and this is precisely where problems began.

As with most such panic situations these days, the first salvo was fired by an equity analyst who on July 7 questioned the impact of a new accounting change for the two agencies. The analysis of one of its financial brethren by Lehman Brothers, itself a troubled investment bank (see The gullible and the greedy, Asia Times Online, July 4, 2008, for my comments about financial firms criticizing each other), set off a storm of stock selling, with the two agencies’ share prices falling some 18% on the day alone. Interestingly, shares of Lehman are down around 22% in the past two days alone, making the year to date decline 75%.

The rule change mentioned by Lehman that would hurt the two agencies was soon enough postponed to a later date by the ever-accommodative accountants at the Financial Accounting Standards Board (FASB), who after all do not want their most important companies going bust for accounting reasons. The damage though had already been done. In their roles as guarantors of mortgage debt originated in the US, the activities of the two government agencies resembles reinsurers such as MBIA whose solvency has also been severely questioned over the course of this year.

As a quick explanation of the proposed rule change, FASB has pushed for greater financial transparency in statements for all financial institutions by making them consolidate liabilities that are currently not recorded on published balance sheets due to the use of SIVs. Last year’s problems with SIVs, along with the losses of money market mutual funds and other investors with exposure to short-term debt issued by those vehicles, was on account of a lack of visibility on explicit and implicit support by sponsoring financial institutions.

In pushing through the rule change intended for commercial banks, FASB may have inadvertently set off problems for the two federal agencies, which guarantee gargantuan amounts of bond issuance backed by mortgage debt. Such guaranteed debt is held to the tune of hundreds of billions of dollars by central banks in Asia and the Middle East, for example, which is the reason that concerns about the two agencies quickly become a global problem.

This isn’t the first time that the two agencies have run foul of accounting changes. Events over the course of 2002-03 meant that their practices for hedging interest rate risk were inconsistent with approved methodology, as regulators found the two agencies to have indulged in excessive trading for what was supposed to be pure hedging transactions.

The resulting move of financial derivative income directly to the income statement saw the most significant earnings volatility associated with the two agencies, necessitating extensive communications with major investors in Asia about the problems. In that period, Asian investors ended up supporting the two agencies, giving them a life line by purchasing new securities backed by the agencies.

Poole and other comments

Once again proving the adage made popular by former Federal Reserve Board chairman Paul Volcker that retired central bankers should neither be seen nor heard, former Fed board member William Poole mentioned in a speech this week that Fannie Mae and Freddie Mac were essentially insolvent.

While the argument for disbanding Fannie Mae and Freddie Mac has been made by right-wing media in the US for a long time now on grounds of competitive advantages bestowed by the close relationship with the US government, the comments by Poole were of a different nature in that markets interpreted them as concerns of a former central banker with indirect supervisory responsibilities. As the agencies often represent the biggest counterparty risks of many US banks, concerns of the former Fed member were seen as important.

In their testimony to the House Financial Services Committee later in the week, both Treasury Secretary Hank Paulson and Fed chairman Ben Bernanke mentioned the difficulties being faced by the two agencies on account of the declining credit quality of mortgage assets in general, contingent liabilities as mentioned above and potential funding restrictions. While the US government is clearly going to support the agencies, the question of moral hazard become germane – after all, Paulson mentioned in the same testimony that some financial firms should be allowed to go bust in the current crisis.

As events gathered pace, by this morning in New York (July 11), we should expect some sort of official statement about the future of the agencies, as is being suggested by the online versions of many US newspapers. Reacting to the first set of headlines, Asian stock and credit markets rebounded strongly from their weak levels, while the potential for the US government to take on greater debt obligations pushed 10-year US Treasury yields higher by 6 basis points.

This last point, going to the very credit quality of the US government itself, is significant. On the back of the Japanese financial crisis in the 1990s, the government there absorbed the financial risk of its banking system over and over again, eventually losing its own prime credit ratings – a stunning rebuke for the world’s largest creditor nation of that time.

Unlike Japan of that time, the US is running a massive fiscal deficit that threatens to get worse with the recession even as Republicans demand more tax cuts and other measures designed to make the problem worse. With bank after bank in trouble, and an almost endless moral hazard net being thrown by a feckless government, it appears likely that the much-vaunted triple A credit rating of the US government could come under a cloud sooner rather than later. This will be a fitting end to the decades of excess in that country. The time to pay the piper has arrived, with a bang.