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John Quiggin

Free-market facade cracks

John Quiggin Australian Financial Review

11 September 2008

Measured by the dollar amount involved, the effective nationalisation of the mortgage guarantors Fannie Mae and Freddie Mac, announced over the weekend by the Bush Administration, is the largest in history. No less than $5 trillion of obligations have been taken over by the US government in one hit.

Of course, that debt had long been regarded as having an implicit government guarantee and the companies involved were quasi-public anyway. Fannie was a government agency privatised in the 1960s, with Freddie created to give it some apparent competition. So, even though the US government will now guarantee virtually all new mortgages, this is more an admission of existing reality than a step towards socialism.

The real significance of the event is not in the marginal change in the status of Fannie and Freddie from quasi-private to quasi-public, but in the abandonment of the pretence that the normal operations of financial markets are capable of cleaning up the mess they have created, even with liberal helpings of public money.

This event has a range of implications. First, it foreshadows continued deleveraging and a partial or complete reversal of the explosive growth in securitization that has taken place over the last decade or two. Many products of structured finance may well disappear permanently.

The $250 billion auction rate securities market, for example, collapsed suddenly in February 2008, and banks are being forced to take buy many of the securities back from the holders. The global issuance of Collateralized Deposit Obligations (CDOs) in the first half of 2008 was only $36.8 billion, a drop of about 90 per cent compared to the same period in 2007. Synthetic funded CDOs, based on credit default swaps have disappeared almost completely, according to the Securities Industry and Financial Markets Association.

The big question for financial markets is whether the trouble will spread to the Credit Default Swap (CDS) market, which reached a notional coverage of $US 60 trillion by the end of last year, though the gross market value of the associated insurance contracts is ‘only’ $US 2 trillion.

Nationalisation has triggered a default event for Fannie Mae and Freddie Mac, which account for $1.4 trillion of notional values. These deals will have to unwound, which may be may be problematic with so many of the parties involved facing severe financial stresses of their own. And because Fannie and Freddie are members of the benchmark index of U.S. credit risk, many other index-based CDS swaps will also be triggered.

The failure of so many financial innovations has broader implications. A central idea in recent policy discussions is the claim that asset prices determined in financial markets are a more reliable source of economic information than the data on flows of output, income and expenditure on which economists have traditionally relied.

So, the fact that mortgages issued to subprime borrowers could be converted into AAA-rated financial assets, trading at a modest premium to government bonds, implied that these mortgages were sound investments even when the borrowers fell into the NINJA (no income, no job or assets) class. Similarly, old-fashioned concerns about the sustainability of current account deficits can be dismissed as long as markets are willing to fund those deficits.

Such claims now seem considerably weaker. In particular, the willingness of financial market participants to rely on model-based AAA ratings for assets with no real track record has turned out to be an open invitation to game the system. The credibility of the ratings agencies has been irreparably damaged.

More broadly still, the neoliberal reform agenda that dominated the late 20th century, and remains highly influential, must be called into question. A central claim underlying the neoliberal agenda is that lightly regulated capital markets allow individuals and households to handle the risks they face more flexibly and efficiently than the combination of tightly regulated capital markets and a social-democratic welfare state. It’s hard to see how this claim can be sustained in the light of the current crisis.

Institutional changes, such as the end of defined-benefit pensions appeared to substantial risk from governments and firms to households. Households have been pushed to manage their own risks through financial markets, whose participants have been richly rewarded for innovations that seemed to reduce the cost of risk.

But attempts by governments to shift risk away from themselves, and on to financial markets, have failed. Instead of acting directly to protect households they have now been forced to bail out the markets.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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