PART 3
Conventional wisdom suggests that a good credit rating is necessary to borrow. But the financial world works differently in reality. A good credit rating is first necessary to issue credit. Without the ability of some entity to issue credit, no one can borrow. And since no modern financial institution lends its own money, lenders must first secure funds wholesale to lend to retail borrowers. For that, a lender must maintain a good credit rating.
Banks are protected from this requirement by their discount window at the central bank, which is backed by the full faith and credit of the nation, and by Federal Deposit Insurance Corp (FDIC) insurance. Still, central banks and the Bank of International Settlement (BIS) set capital and reserve requirements for commercial banks to assure risk prudence.
GE, the world's largest non-bank financial conglomerate that incidentally also manufactures, issues credit at the retail level through vendor financing, to capture sales for GE products. It gets its funds wholesale from the commercial paper market, which GE dominates because it has a good credit rating. When GE credit rating was downgraded recently, it faced being frozen out of the commercial paper market, and had to revert back to costly bank credit lines that adversely affected its interest rate spread and profitability.
When a government issues currency and circulates money through the banking system, it is in essence issuing credit to the economy that it is entitled to receive back in taxes. Government then spends the tax money on goods and services that the public provides. The surplus money that is not returned by taxes is government credit floating around the economy to keep it operating financially.
It is important to understand that money issued by the government, unlike private money, is not IOUs from the issuer. Money, when issued by government as a legal tender, is a credit from the government good for the payment of taxes, and for settling "all debts, public and private", as printed plainly on all Federal Reserve notes. A US dollar is a Federal Reserve note that entitles its holder to exchange it at any of the six Federal Reserve Banks for another Federal Reserve note of the same face value, no more and no less, at least since 1971 when the late president Richard Nixon took the dollar off the gold standard.
Even before 1971, while an ounce of gold was officially pegged at $35 by president Franklin Roosevelt on January 31, 1931, a domestic holder of a dollar note could only exchange it at a Federal Reserve Bank for another dollar note, since US citizens were forbidden by law to own gold. Only foreigners could demand gold for dollar up to 1971.
A government bond, which on the surface looks like a government debt, is merely a call on government credit previously issued, withdrawing dollars from the money supply by providing a government bond. Government bonds are the living proof that money is not an IOU from the government, otherwise when government sells or redeems bonds, it is perpetrating a Ponzi scheme of paying off old debt with new debt, rather than exchanging debt instruments (bonds) with credit instruments (dollars).
Sovereign debt is fundamentally different from corporate debt. A corporate bond entitles its holder to claim its face value in dollar notes that the bond-issuing corporation cannot create by itself. It must earn dollars with the bond proceeds to pay interest on the bonds. At the time of redemption, if the corporation already spent the bond proceeds, it must then earn back or sell assets or borrow the dollars from somewhere to redeem the bond.
In contrast, a government bond entitles its holder to claim from a Federal Reserve Bank its face value in dollars that the government can print at will, even if it already spent the bond proceeds. The interest on the bond is also paid with dollars of which the government has an unlimited supply. Part of the dollars that the government spends will come back from the public in the form of taxes. The rest will stay in the economy to finance its operations.
So if the government runs a surplus, meaning it takes in more tax money than it spends, it drains money from the economy, forcing the economy to contract. A budget deficit is in essence an injection of more government credit into the economy.
Private citizens can own assets, but whenever such assets are monetized with dollars, one trades those assets for credit from the US government that other market participants in the economy will accept because, aside from its status of legal tender as defined by law, it is good for negotiating tax liabilities.
Technically, a government never borrows. It issues tax credit in the form of money. So when former president Ronald Reagan said the government does not make any money, only the private sector does, he was merely mouthing conventional wisdom, with no clear understanding of the true nature of money and credit. In fact, money is all that government makes. Thus any government that takes on foreign-currency debt or allows its economy to do so is taking unnecessary risk.
The main function of sovereign debt is not to make up for any shortfalls in government funds. Such shortfalls cannot exist by definition. Rather, sovereign debt instruments act as fundamental collateral for the nation's credit market. The Fed Open Market Desk buys and sells government securities to maintain the Fed funds target rate set by the Federal Reserve Board. The repo (repurchase agreement) market, which provides overnight and short-term funds for banks, operates with government securities as collateral.
Thus IMF conditionalities of reducing sovereign debt by imposing budget surpluses and price deflation as a cure for a distressed credit market of excessive foreign debt is merely adding gasoline to fire.
As a sovereign bond is redeemed with cash, it is in essence replacing a call instrument on government credit with government credit. When government securities are withdrawn and cash floods the economy, the debt market shrinks because the amount of collateral shrinks and the amount of cash increases, reducing the need for credit, and the economy contracts with cash inflation, unless the cash is immediately recirculated as private debt or investment.
The reason that the market monitors the Fed funds rate as an indication of Fed policy is that the Fed funds rate closely tracks another rate, the repo rate, that the Fed Open Market Desk actively influences during most market days. Every business-day morning at 11:45 Eastern Standard Time, the Fed announces what it intends to do (buying or selling government securities with an agreement to reverse the transaction later) in the repo market to keep the repo rate close to the Fed funds target rate set by the Fed. Changes in the repo rate are normally quickly followed by changes in the Fed funds rate. Thus, indirectly, the Fed appears to influence the federal funds rate through its impact upon the repo rate.
Non-monetarists subscribe to the view that Fed easing means the Fed lowers interest rates. But they are not specific about how these rates are lowered are how the Fed should go about doing this. There are often periods (such as 1990-91) when interest rates dropped but money growth also fell. Non-monetarists (and market participants) view periods like this as Fed easing episodes, while monetarists argue that these are (implicitly) periods of Fed tightening. Thus it is clear that interest rates by themselves do not always determine the money supply.
Since all private debts in a money economy are anchored by government credit, through what economists called high-power money (money created by the Fed through the increase of the total reserves in the banking system, so called because it would be multiplied manifold through the money-creation power of commercial bank loans), credit in an economic democracy should not be rationed by interest rates to the highest bidder, but by national purposes or social needs.
Credit in fact is a financial public utility, much like air and water, and it should be equally accessible to all, not just the rich. Government loan guarantees for students and house mortgages for low- and moderate-income groups and loans to small business are based on this principle.
For example, the US National Housing Act was enacted on June 27, 1934, as one of several economic-recovery measures of the New Deal. It provided for the establishment of a Federal Housing Administration (FHA). Title II of the Act provided for the insurance of home mortgage loans made by private lenders, taking the risk in lending to low income borrowers off the private lenders. Title III of the Act provided for the chartering of national mortgage associations by the administrator. These associations were to be independent corporations regulated by the administrator, and their chief purpose was to buy and sell the mortgages to be insured by the FHA under Title II.
Only one association was ever formed under this authority on February 10, 1938, as a subsidiary of the Reconstruction Finance Corp, a government corporation. Its name was National Mortgage Association of Washington, and this was changed that same year to Federal National Mortgage Association (Fannie Mae). By amendments made in 1948, Title III became a statutory charter for Fannie Mae.
Before the Great Depression, affording a home was difficult for most people in the United States. At that time, a prospective homeowner had to make a down payment of 40 percent and pay the mortgage off in three to five years. Until the last payment, borrowers paid only interest on the loan. The entire principal was paid in one lump sum as the final "balloon" payment.
During the 1920s boom time in real estate, a rudimentary secondary mortgage market was established. The stock-market crash of 1929 ended the real-estate boom and forced many private guarantee companies into insolvency as home prices collapsed. As economic conditions worsened, more and more people defaulted on mortgages because they couldn't come up with the money for the final balloon payment or to roll over their mortgage because of low market value of their homes.
To help lift the country out of the Depression, Congress created the FHA through the National Housing Act of 1934. The FHA's insurance program protected mortgage lenders from the risk of default on long-term, fixed-rate mortgages. Because this type of mortgage was unpopular with private lenders and investors, Congress in 1938 created Fannie Mae to refinance FHA-insured mortgages.
As soldiers came home from World War II, Congress passed the Serviceman's Readjustment Act of 1944, which gave the Department of Veterans Affairs (VA) authority to guarantee veterans' loans with no down payment or insurance premium requirements. Many financial institutions considered this arrangement a more attractive investment than war bonds.
By revision of Title III in 1954, Fannie Mae was converted into a mixed-ownership corporation, its preferred stock to be held by the government and its common stock to be privately held. It was at this time that Section 312 was first enacted, giving Title III the short title of Federal National Mortgage Association Charter Act.
By amendments made in 1968, the Federal National Mortgage Association was partitioned into two separate entities, one to be known as the Government National Mortgage Association (Ginnie Mae), the other to retain the name Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in the government, and Fannie Mae became privately owned by retiring the government-held stock. Ginnie Mae has operated as a wholly owned government association since the 1968 amendments. Fannie Mae, as a private company operating with private capital on a self-sustaining basis, expanded to buy mortgages beyond traditional government loan limits, reaching out to a broader income cross-section.
By the early '70s, inflation and interest rates rose drastically. Many investors drifted away from mortgages. Ginnie Mae eased economic tension by issuing its first mortgage-backed security (MBS) guarantee in 1970. Investors found these guaranteed MBSs highly attractive. Also in 1970, under the Emergency Home Finance Act, Congress chartered the Federal Home Loan Mortgage Corp (Freddie Mac) to buy conventional mortgages from federally insured financial institutions. The legislation also authorized Fannie Mae to purchase conventional mortgages. Freddie Mac introduced its own MBS program in 1971.
In the early 1980s, the US economy spiraled into deep recession. Interest rates and housing prices were high, while income growth was stagnant. The US economy faced a dual problem of income deficiency and money devaluation. In this poor housing environment, Ginnie Mae, Fannie Mae and Freddie Mac all created programs to handle adjustable-rate mortgages. The Ginnie Mae guaranty is backed by the full faith and credit of the United States. Today, Ginnie Mae guaranteed securities are one of the most widely held and traded MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion in MBSs. Historically, 95 percent of all FHA and VA mortgages have been securitized through Ginnie Mae. Ginnie Mae is a guarantor, a surety. Ginnie Mae does not issue, sell, or buy MBSs, or purchase mortgage loans.
Fannie Mae operates under a congressional charter that directs it to channel its efforts into increasing the availability and affordability of home ownership for low-, moderate- and middle-income Americans. Yet Fannie Mae receives no government funding or backing, and it is one of the nation's largest taxpayers as well as one of the most consistently profitable corporations in America. The company has evolved to become a shareholder-owned, privately managed corporation supporting the secondary market for conventional loans. It continues to operate under a congressional charter with oversight from the US Department of Housing and Urban Development and the US Treasury.
Fannie Mae has two primary lines of business: Portfolio Investment, in which the company buys mortgages and MBSs as investments, and funds those purchases with debt, and Credit Guaranty, which involves guaranteeing the credit performance of single-family and multi-family loans for a fee.
Its Portfolio Investment business includes mortgage loans purchased throughout the US from approved mortgage lending institutions. It also purchases MBSs, structured mortgage products and other assets in the open market. The corporation derives income from the difference between the yield on these investments and the costs to fund these investments, usually from issuing debt in the domestic and international markets. Fannie Mae has $3.46 trillion in MBSs outstanding today.
The corporation accomplishes its mission to provide products and services that increase the availability and the affordability of housing for low-, moderate- and middle-income Americans by operating in the secondary rather than the primary mortgage market. Fannie Mae purchases mortgage loans from mortgage lenders such as mortgage companies, savings institutions, credit unions and commercial banks, thereby replenishing those institutions' supply of mortgage funds. Fannie Mae either packages these loans into MBSs, which it guarantees for full and timely payment of principal and interest, or purchases these loans for cash and retains the mortgages in its portfolio. |
