Thursday, January 10, 2008

Countrywide Financial and Central Banking's End Game

Financial news websites today report that Bank of America is in negotiations to acquire Countrywide Financial, the nation's largest mortgage bank. Countrywide has been plagued in recent days by rumors of its impending bankruptcy, which it has denied. Nevertheless, the reports of an acquisition by Bank of America only fuel suspicions that Countrywide is circling the drain.

How might Countrywide, the largest mortgage bank in the country, be reaching the end of the line? The answer may well be that Countrywide is running out of creditors. Since the subprime mortgage crisis this past summer, Countrywide has encountered difficulties borrowing in corporate debt markets, and has turned to its thrift subsidiary and to the Federal Home Bank System for funding. The thrift has about $60 billion in deposits. It also is the conduit for loans from the Federal Home Loan Bank System, a federally sponsored central banking system for thrift institutions. However, Countrywide does not have a giant retail thrift operation, and cannot easily gather massive amounts of deposits. It has reportedly borrowed about $51 billion from the Federal Home Loan Bank System, but apparently is running of collateral for further loans.

The FHLBS has about $45 billion in capital, so its loans to Countrywide exceed its capital. These loans are secured by mortgages and mortgage-backed collateral. Collateral is only worth what someone will pay for it. If Countrywide went into bankruptcy, the FHLBS would have to sell that collateral. Given today's mortgage markets, do we think there's a chance they might not collect 100 cents on the dollar? Does a bear sit in the woods?

The size of the FHLBS's exposure to Countrywide has created controversy in Congress. It's likely the FHLBS isn't throwing many loans at Countrywide any more. With Countrywide's portfolio of mortgages and home equity loans apparently still deteriorating, who else will step forward and take the place of the FHLBS? And if Countrywide went into bankruptcy, wouldn't the solvency of the FHLBS come into question? If the thrifts lost their central bank, how could they cope with the credit crunch? The hot tamale, dear taxpayer, would circle back to you, just as it did in the thrift crisis of the 1980s.

If Bank of America acquires Countrywide, it will, in effect, bail out the Federal Home Loan Bank System with respect to its exposure to Countrywide. That's nice. But what on earth did the FHLBS think it was doing lending $51 billion to Countrywide? Yes, there's a tenet of central banking that in times of crisis, the central bank should provide liquidity. But there are limits to how much a central bank can lend, since borrowers may run out of permissible collateral and even a central bank's capital is limited. (The alternative, lending an unlimited amount of money, is tantamount to producing an inflationary whirlwind.) Since there are limits to how much the central bank can lend, the central bank needs an end game if its member banks sustain really large losses.

What was the FHLBS's end game for Countrywide? What was the plan for dealing with Countrywide if it couldn't stay in operation? As far as we can discern, there was no end game. And that's the scariest thing of all; because the same analysis applies to what the Federal Reserve is doing with the larger commercial banking system. It has been providing liquidity. A lot of it. But what if the banks' losses turn out to be really, really big? There are rumors that late January could see announcements of very large bank losses. Then what will the Fed do?

Today's Wall Street Journal (1/10/08, P. A1) reports that Citigroup and Merrill Lynch are seeking capital infusions in the billions from foreign sources. It makes sense to look overseas, because there isn't enough available capital in the U.S. to prop up our troubled banking system. Narrow-minded economic nationalists notwithstanding, these foreign infusions of capital are good for us. They give influential foreign financiers investments in the heart of the U.S. financial system and the U.S. economy. The new investors will have an incentive to protect the U.S. dollar, instead of dumping it. Most likely, the Fed is quietly supportive of these foreign capital infusions. After all, what other alternatives does it have?

The risk management deficiencies of the Federal Reserve, Federal Home Loan Bank System and other bank regulators have become glaringly obvious. We now have Bank of America very possibly bailing out the FHLBS. What's next? The central banks of China and Japan, maybe with the help of the Saudis and the Persian Gulf states, bailing out the Fed? If they can't or won't, what's Plan B? And, furthermore, what will the federal banking regulators do to prevent a crisis like this from happening again?

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