Woodrow Wilson "I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated Governments in the civilized world, no longer a Government by free opinion, no longer a Government by conviction and the vote of the majority, but a Government by the opinion and duress of a small group of dominant men.”

— President Woodrow Wilson, in reference to the
Federal Reserve Act of 1913, which he signed into law.

When Bear Stearns got into difficulty in March of this year, a "bailout" was arranged by which JP Morgan Chase agreed to buy the investment bank provided that the Federal Reserve guarantee JPM against losses up to $29B. Until that moment, the Fed’s role – in part – was thought to be  as a lender of last resort for commercial banks only.  In April Paul Volcker, ex-Fed Chairman, was quoted saying:

"The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.”

Since then, the Fed has expanded its domain still further and devised novel means to funnel additional cash into the system in its effort to "bail out" investment banks. The Fannie-Freddie debacle is now another occasion for the Fed to extend its jurisdiction and oversight far beyond that originally contemplated in 1913 when the Fed was authorized to be the keeper of the financial keys.

The $173B Economic Stimulus Package passed by the Congress authorized FNMA to acquire residential loans up to $729,750 or 125% of the median home sales price in that particular MSA. This made room for FNMA to acquire existing loans far in excess of their previous maximum limit ($417,000). It is easy to understand Secretary Paulson’s dilemma; it is somewhat akin to that  of Chairman Bernanke. Fannie Mae is leveraged to an extraordinary degree. While most banks are required to maintain reserves in the order of 8-10% (~ 10:1 ratio) of their capital, Fannie maintains reserves of approximately $83 Billion to support loans of approximately $5.2 Trillion, a 60:1 ratio. It takes a relativity modest decline in the value of the loan and loan guarantee portfolio to declare the GSE bankrupt.

Officially, Fannie and Freddie are privately owned corporations, are not government agencies, and are not legally entitled to special financial treatment. Although voices continue to proclaim that the GSE’s debt is not guaranteed by the Fed, the GSEs enjoy the implicit support of the government allowing them to borrow money at rates substantially below that of other banks.  If the government failed to "bail out" Fannie and Freddie in a time of crisis it could reasonably be expected that foreign governments would  judge the U.S. unwilling to  honor its debts. The crash of the U.S. dollar would be deafening.

If, on the other hand, the government steps in to rescue this private enterprise under the "too big to fail" doctrine, then the  Fed will surely have exceeded Mr. Volcker’s "..very edge of its lawful and implied powers.."

The Congress has now seen fit to increase FNMA’s total lending limits by $300B until 12/31/08. Increasing the individual loan limit and the total value of loans that Fannie may acquire is designed to allow Fannie to refinance sub-prime loans and replace them with fixed-rate mortgages not greater than 90% of the property’s new assessed value – all of this provided the lender takes at least a 10% haircut on his loan.

Worse still, the newly passed legislation provides an additional $2.5B line of credit to Fannie-Freddie and a blank check to Secretary Paulson to buy equities in the GSEs "if necessary."

Although the U.S. government is not obligated to rescue Fannie and Freddie in an emergency, some deem it unthinkable it would not. Not to do so, they contend,  would transfer $5.2 Trillion in mortgage liabilities to the $9.5 Trillion of existing U.S. debt, sinking the value of the dollar.

But there are those who stoutly contest this assertion, pointing out that approximately $100M of the $5.2Trillion is at risk of default. These individuals feel that the U.S. could easily handle the $100M loss but would be rid of Fannie and Freddie forever.

What remains certain is that the Treasury and Federal Reserve have already injected a prodigious amount of capital into the banking system to shore up failing enterprises. This year’s trade deficit is likely to exceed $600B and an operating deficit of more than $500B, not including the costs of the Iraq and Afghanistan wars. The question is: "Where is the money to pay these deficits coming from?"

In the past we have relied on the kindness of strangers who recirculated our petrodollars by buying U.S. Treasuries. But with Treasuries paying rates far below the true inflation rate is it reasonable to expect that foreigners – however kind – will continue to invest in  U.S. securities ?

In the absence of a financial genie, we see the day soon approaching   when the U.S. will be unable to finance its entire debt and that the Treasury Department will begin to monetize the debt by issuing Treasury Notes which the Federal Reserve Bank will buy,  thereby inserting additional dollars into the system. The rescue of other "too big to fail" entities cannot be far behind.

"With what money, you ask?"
Why with fiat money, of course.