The financial crisis, politics, and the Middle Kingdom.
Today I’m recounting a book that grabbed my attention better than the other I read on my trip, which is detailed here. The short 150-page work China and the Mortgaging of America, by University of Cambridge professor Helen Thompson, delves into the issue of how and why the U.S. set up a risky borrowing market that the Chinese government and economy threw money at and ultimately backed out of, culminating in the global financial crisis. If you ask former Federal Reserve chairman Ben Bernanke, he’ll tell you that a global savings glut was largely to blame for low long-term interest rates in the mid-2000s. I think it’s important to understand these cross-border flows, mainly to avoid the above-mentioned crises but also because of other potential consequences. I’ll look into it myself for a future post, but for now, here are Thompson’s findings:
- The faith of China and Japan in U.S. housing finance was tested – with big consequences for the U.S. housing finance agencies. A large part of the crisis was onset by Fannie Mae and Freddie Mac’s inability to meet debt payments as their primary creditors, the Chinese and Japanese central banks halted their exposure and began selling off their holdings of mortgage-backed securities (MBS). Leading up to the crisis, the Chinese and Japanese governments believed that the government-sponsored enterprises (GSEs) were backed by the full faith and credit of the U.S. government, if only implicitly, like any U.S. treasury bond. When they began to fear that it wouldn’t, they began cutting their losses.
- The roots of the savings problem partially stem from another financial crisis. The Asian financial crisis of the late 1990s put Asian governments on edge; they believed that by stocking up on foreign exchange reserves, they would be able to fare in future crises much better. They sure succeeded: between 1999 and 2007 foreign exchange reserves in Asia swelled by nearly $2.5 trillion. Then there was China, who, while not affected by the crisis, was terrified by the situation. China set about growing savings–by 2006 the savings ratio to GDP was a whopping 60 percent–and buying up dollar-denominated debt, most notably Treasuries.
- And then there was the demand for borrowing. This demand came from both the public and private sectors. The federal deficit returned after the transition from Bill Clinton to George W. Bush. Thompson makes the interesting point that “the Bush administration was practically able to operate without an interest rate constraint on borrowing because the east Asian states and other foreign investors were willing to lend at a loss”–this of course enabled the financing of the war in Iraq and the large tax cuts for the richest Americans. There was also trouble brewing in the private sector, though, as households and the financial sector increased their borrowing, mainly for mortgages, borrowing that could hardly be sustained by American savings alone; the household net savings rate fell from 10 percent in 1980 to 0.5 percent in 2006. Yeah. Americans aren’t good at the whole savings thing.
- The demand for this borrowing came from our culture of home ownership. Thompson argues that there was broad support from both parties to encourage home ownership among Americans, tasking the federal housing agencies with promoting this ideal. There was a social justice aspect of this campaign, as well. Thompson traces the origins of Fannie Mae, Freddie Mac, and Ginnie Mae and in so doing, highlights that in the early decades, from around the ’30s to the ’60s, the agencies created racist policies that discriminated against black and other minority mortgage borrowers, even denying them flat-out. It was clear that the agencies had originally been created for aiding white homeowners. One of the agencies’ manuals focused on “social harmony,” aiming to keep blacks out of white neighborhoods.
With policies that divisive, at some point the government wanted to reverse decades of discrimination. From the 1990s the agencies were pressured to lend to minority borrowers to increase their rates of home ownership; it was argued that this would improve the often downtrodden communities they lived in. Of course, these borrowers were generally a lot poorer than the average mortgage borrower; the agencies had to loosen some of the usual criteria, to open their aid to the ‘subprime’ category of borrower. Democrats especially devoted themselves to this cause, and when concerns were brought to Congress about the risks run by this strategy, they were usually the first to dismiss them. I find it somewhat ironic and illustrative of the law on unintended consequences; while the campaign run by Congress was meant to help African-Americans and other minorities, among the groups hardest hit by the recession that resulted from the risk? African-Americans.
- Fannie Mae and Freddie Mac were always controversial agencies. It wasn’t as if Congress never heard of the risk that the agencies posed to the financial system. Washington was aware that Wall Street had taken these mortgages and securitized them, spreading them through the global financial system. But testimonies from the agencies’ regulator were dismissive and within the agencies, risk officers were fired. For Republicans, it was difficult to voice concerns about the problem without appearing to be embarking on a campaign against minorities or American home ownership. And it was always ambiguous that if the agencies were to face financial trouble, the federal government would bail them out. Those in the Chinese government and others, assumed that they would.
- As the crisis unfolded, China was definitely in the spotlight. As firms lost access to capital, they sought it from sovereign wealth funds in Asia and the oil exporting countries, including the China Investment Corporation, but of course these began to retreat. China’s central bank continued to buy U.S. Treasuries, even as the dollar’s value and interest rates came down, but also because of the dollar’s depreciation. The yuan was subject to upward pressure. But its and other Asian central banks’ purchases they couldn’t stop the dollar’s fall; the Fed’s cuts in interest rates saw to that, leading to losses on the dollar-denominated portions of China’s portfolio. On the whole, though, Fannie and Freddie didn’t have the support of foreign creditors anymore. In addition, China put pressure on the federal government to save them. This left the Bush administration in an awkward spot; it had to rescue the corporations, putting them into conservatorship and raising the national debt by $800 billion.
- It was a situation over which neither nation really had much control, and in which everyone was exposed. Though China was the lender in the relationship, it couldn’t resolve the crisis or bend America to its will. It was bound by its portfolio, much of which was dollar-denominated, the exchange rate, and the exposure of its own financial system. For its part, the U.S. was constrained by the need for foreign capital, a crisis of confidence in the U.S. economy and in the dollar, and the federal government’s own limitations. Thompson’s point is to illustrate the economic interdependence that has developed between the two, one that will only become more important with the passage of time.