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State Is Now Dominant Force in US Capital Markets

By the time you read this column today, a fascinating shift will almost certainly have occurred in the nature of US finance: for the first time the government will be the biggest source of outstanding home mortgage and consumer credit loans in the US, eclipsing private sector banks or investors.

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Or that, at least, is the forecast recently made by Investor Business Daily, a US publication. It recently crunched some Fed data and concluded that the volume of outstanding government-financed mortgage and consumer credit was running at $6,320bn in the US in the first quarter of this year – up from $4,400bn in late 2006. However, private credit provision was just $6,580bn, down from $8,480bn in 2006.

Thus, if you extrapolate recent trends, this private sector lead was almost certainly eliminated in the second quarter of this year. Indeed, if you include the outstanding $500bn-odd worth of state-backed student finance in the sums, then government funding has already topped private sector loans, IBD says – albeit without any fanfare.

What should investors make of this? There are at least three lessons to ponder. First, the data provide a powerful sign of just how distorted the US financial system remains in the aftermath of the great credit crunch. This might not seem obvious to investors or voters; after all, in recent months the large banks have repaid their troubled asset relief programme funds, stock markets have rallied and credit spreads have shrunk.

But behind this veneer of normality, banks are still deleveraging, and the private sector mortgage securitisation world remains almost dead. Indeed, were it not for the activity of Fannie Mae and Freddie Mac, the giant state institutions, mortgage finance would, in effect, have seized up in the past three years.

The second fascinating point, though, is the cognitive dissonance surrounding this pattern. Six years ago, when I first started writing about the credit markets, I often heard US financiers praise America’s capital markets as the most developed system of free market finance in the world. Indeed, techniques such as securitisation were presented as a natural outcome of American enthusiasm for free market ideals.

But the dirty secret behind this rhetoric was that government-backed institutions such as Fannie and Freddie were playing an important role in the modern financial system, even before the credit crisis erupted. And what is remarkable now, given that the role of Fannie and Freddie has swelled, is just how little debate this patter continues to generate. After all, with the US remaining wedded to free market ideals, it is uncomfortable to admit that “capital markets in the US have become reliant on government guarantees”, says Viral Acharya, an economist and co-author of a thought-provoking book.*

And that raises a third big question: namely, where will the limits of America’s sovereign balance sheets lie in the future? Back in 1968 the US government privatised Fannie Mae partly because it wanted to remove it from the government accounts. But during the 2008 crisis, Fannie and Freddie were placed in “conservatorship”, leaving taxpayers on the hook for at least $175bn of losses. (As Prof Acharya observes, the two entities wrote $3,500bn of loans on risky assets in the boom, with minimum collateral, which makes AIG’s adventures seem almost tame in comparison).

So does this mean that Fannie and Freddie should now be reincorporated into the official calculations of government debt? What about student loans, or many other forms of state-backed finance? Right now, it is not entirely clear. Like so much, these entities lie in an accounting limbo land.

Nevertheless, the one thing that is clear is that sooner or later investors are likely to start asking harder questions about this. After all, the eurozone has already provided one wake-up call about the problems posed by contingent – or half-stated – state guarantees. Just look, for example, at how bank debt has suddenly become sovereign debt in Ireland. Or how lawyers are now trying to work out how to treat state-owned and state-backed enterprises in Greece, if the sovereign debt is rescheduled.

Of course, the US is in a very different situation; there is no debt crisis yet. And the good news is that Congress and the Treasury are supposed to be developing proposals to reform Fannie and Freddie, with a view to putting a more rational system in place in the future. But don’t bet on that happening soon. With an election looming, few politicians really want to rock the boat. It could be a long time, in other words, before private sector finance really dominates again in the US consumer world. It is a peculiar – unexpected – irony. Adam Smith might spin in his grave.

*Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance

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