Trade

Afta Doha

Should free traders applaud the rise of preferential trade deals?

CONTEMPLATING the failure of the Doha round of multilateral trade talks, which collapsed in Geneva in July, Peter Mandelson, trade commissioner of the European Union (EU), predicted that by the time the talks resumed, “the caravans will have moved on elsewhere.” On August 28th they trundled through Singapore. The ten members of the Association of South-East Asian Nations (ASEAN) agreed on a trade deal with India and reached a separate accord with Australia and New Zealand. Together, the agreements cover trade worth about $70 billion in 2006.

After the Geneva disappointment, some free traders find consolation in the success of bilateral and regional deals, such as those agreed on in Singapore. Since the Doha round was launched almost seven years ago, over 100 such deals have come into force, lowering tariffs for some members of the World Trade Organisation (WTO) but not others (see map).

These preferential deals violate the principle of “most-favoured nation” (MFN), which holds that any favour offered to one member must be offered to all. But that principle now has few defenders in the world’s trade ministries. In his new book, “Termites in the Trading System”, Jagdish Bhagwati of Columbia University points out that negotiators see any deal as a “feather in your cap”. But economists know better. By playing favourites with its trading partners, a country can dupe itself into paying more for its imports. Its consumers may switch from a low-cost supplier to a more expensive one, only because the new supplier can sell its goods duty-free and the other cannot. The consumer pays less, but the Treasury is deprived of tariff revenue. Thus discriminatory trade deals do not just hurt those left out.

ASEAN, however, seems a compelling advertisement for regionalism. Its members (which include Indonesia, Malaysia, the Philippines, Thailand and Vietnam) have only 3% of the world’s land area but 11% of its coastline, which extends for 173,000 kilometres around the region’s peninsulas and archipelagos. ASEAN’s prosperity depends on trade: its ratio of exports to GDP is almost 70%.

The group’s economic geography is as spectacular as its topography. Elaborate networks of production span the region and extend to China, Japan and South Korea. Much of the region’s trade is in parts (such as car components) and tasks (such as assembly) rather than finished goods. It has become part of what Richard Baldwin, of the Graduate Institute of International Studies in Geneva, calls “Factory Asia”.

Some of this success may be due to the ASEAN Free-Trade Area (AFTA), which has cut barriers between members and attracted foreign direct investment. But Factory Asia also demonstrates the flaws of such agreements. If a country wants to grant favours to one trading partner but not all, it has to write complex “rules of origin” to establish the nationality of a product.

But in a dense network of production, every product is a mongrel, with an indecipherable pedigree. In recognition of this, AFTA’s rules of origin are quite relaxed: a good qualifies even if only 40% of its value was added in the region, and that 40% can come from more than one member.

Even so, ASEAN’s success owes more to ambitious cuts in its MFN tariffs, which it applies to everybody. Thailand, for example, slashed its average tariff from 41% in 1989 to 18% in 2000; Indonesia cut from 25% to 8%. If the MFN tariff is low enough, exporters will pay up rather than trouble themselves with documenting the origin of their products. Only 5% of ASEAN trade takes advantage of the preferences its officials so painstakingly negotiated.

If multilateral liberalisation were proceeding apace, firms everywhere could bypass the thicket of preferential agreements, just as South-East Asian companies have bypassed AFTA. But do such accords help or hinder the cause of full liberalisation?

Mr Bhagwati insists that they hinder it. One of the stumbling blocks in the Doha round, for example, was “preference erosion”. Some African and Caribbean countries did not want to see the EU open its banana market to all and sundry, because that would erode the value of their privileges. (This issue was reportedly resolved at the Geneva summit in July.)

Sometimes it is the countries granting the privileges that want to preserve their worth. America, for example, offers trade deals to strategic allies as a reward for fighting the war on drugs or stabilising the Middle East. Nuno Limão, of the University of Maryland, has shown that in the last global trade round America was slower to cut MFN tariffs wherever that would remove a plum from its allies’ mouths.

But not all of the evidence is as gloomy. A new study, by Antoni Estevadeordal of the Inter-American Development Bank, Caroline Freund of the World Bank and Emanuel Ornelas of the London School of Economics, reaches a more optimistic conclusion. Looking at ten Latin American countries in the 1990s, they show that preferential cuts in a tariff were often followed by multilateral cuts in the same tariffs.

This may be the result of what Mr Baldwin calls the “juggernaut effect”. A trade deal, even a discriminatory one, should enlarge a country’s export sector and shrink domestic industries vulnerable to foreign competition. This will, in turn, change the country’s politics, strengthening the “mercantilist” lobby, which demands open markets overseas, and weakening the country’s protectionist constituencies. If the export lobby gets its way, freer trade will follow, further strengthening the mercantilists at the expense of the protectionists. The juggernaut, Mr Baldwin writes, is slow to start rolling, but hard to stop.

Will India’s ASEAN deal get the juggernaut rolling in India? Unfortunately, the agreement protected 489 politically sensitive items, mostly agricultural products. The deal thus gives India’s exporters a little of what they want, reducing their incentive to fight for a Doha round. But it still leaves the country’s farmers with every reason to resist a return to Geneva.

The word “juggernaut”, Mr Baldwin notes, has an Indian origin: it is a British mispronunciation of the Hindu deity, Jagannath. Each year, the deity is worshipped in a garlanded chariot, pulled through the streets by pilgrims. The caravans may be moving as Mr Mandelson predicted. Unfortunately, India’s free-trade chariot seems stuck somewhere between Singapore and Switzerland.

Going up

University attendance is growing

STUDENTS are going to university in unprecedented numbers. In 2006, 56% of school-leavers in industrialised countries went on to university, up from 37% in 1995, according to an OECD report published on Tuesday September 9th. Nearly all of the 30 OECD countries have seen entry rates increase, and the extra cash needed has come from a variety of sources. Some countries, such as Britain, charge tuition fees, whereas Nordic countries levy high taxes. But America spends the most on each university student, thanks to a large pot of private financing.

Fannie, Freddie Takeover Jolts Preferred Market as Prices Fall

Sept. 10 (Bloomberg) -- Treasury Secretary Henry Paulson's takeover of Fannie Mae and Freddie Mac is roiling the market for preferred securities.

Prices of fixed-rate preferred stock fell an average of 9 cents to 71.5 cents on the dollar this week, according to Merrill Lynch & Co. index data, the biggest two-day drop in more than a decade. The 11 percent decline compares with a 1.4 percent drop in the Standard & Poor's 500 index over the same time.

In putting Fannie and Freddie in conservatorship, Paulson scrapped dividends on the mortgage finance companies' equity securities and said the U.S. would buy as much as $200 billion of preferred stock ranking ahead of existing issues. Investors are more hesitant to invest in similar securities of other financial institutions on concern Paulson set a precedent for issuers. Unlike common stock, preferreds typically carry fixed dividends.

Paulson's ``actions have damaged the preferred market,'' said Thomas Hayden, the investment strategist for Liberty Bankers Life Insurance in Dallas. ``Somebody is going to be looking at an issue of Fannie or Freddie preferred shares that were rated AA up until a few months ago. If that's not money good then what about the small regional bank in some part of the country?''

Hayden, whose $1.5 billion fixed-income portfolio contains preferred shares of Fannie and Freddie, said he's ``not interested'' in buying any more preferred securities.

Rising Costs

The market's tumble is making it more expensive for banks and brokers trying to raise fresh capital after taking $506 billion of writedowns and losses on the collapse of the subprime- mortgage market.

Sales of preferred securities in the U.S. have risen 48 percent this year to about $44 billion from more than $30 billion in the same period of 2007, according to data compiled by Bloomberg. The average yield as measured by the Merrill index has risen to 10.1 percent from 8.8 percent on Sept. 5 and 7.9 percent at the end of last year.

The takeover was ``unambiguously bad'' for preferred investors and ``likely set a precedent for any future rescue transactions,'' Kathleen Shanley, an analyst at bond research firm Gimme Credit LLC in Chicago, wrote in a Sept. 7 report.

Preferred shares of Washington-based Fannie and Freddie of McLean, Virginia were cut to the second-lowest rating by Standard & Poor's and Moody's Investors Service on Sept. 7. The grades were slashed 11 levels by S&P to C and 10 rankings to Ca by Moody's. Moody's rated their preferred stock Aa3, the fourth- highest grade, until July.

Biggest Losers

Freddie preferred shares have lost 83 percent the past two days, while Fannie's have declined 80 percent, the biggest losers in the Merrill index. The two companies account for about $24 billion of the $190 billion par amount in the index. Forty of the top 50 issuers have declined in the last two days.

The declines are particularly stinging for Fannie and Freddie investors because the companies have sold $20.4 billion of the preferred securities since November.

Paulson tried to calm preferred stock investors when he announced the rescue of the government-sponsored enterprises and said the takeover shouldn't have negative implications for the wider market.

``Preferred stock investors should recognize that the GSE's are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly,'' Paulson said in a Sept. 7 statement. ``The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.''

Lehman, Merrill

Lehman Brothers Holdings Inc. is down 42 percent, while Merrill Lynch has tumbled 16 percent.

``In the primary market it's going to be much more difficult for financials across the board,'' Hayden said. ``If Lehman Brothers thought they needed to go to the market and had any chance at all of issuing preferred stock to raise capital, it is now three times more difficult than it was last Friday.''

Mark Lane, spokesman for Lehman Brothers, and Danielle Robinson, spokeswoman for Merrill, declined to comment. Lehman and Merrill are both based in New York.

Investors will be ``gun-shy'' about buying preferred shares, said Thomas Houghton, who manages $2 billion of corporate bonds at Advantus Capital Management in St. Paul, Minnesota.

``There are a number of financial institutions that are experiencing distress right now, so the dividend on the common and the preferred share are going to be the first to go,'' he said.

Oil Rises After OPEC President Calls for End to Overproduction

Sept. 10 (Bloomberg) -- Crude oil jumped in New York as OPEC President Chakib Khelil called on members to stop producing more than the group's set quota after prices fell to almost $100 a barrel.

The Organization of Petroleum Exporting Countries is producing about 520,000 barrels a day more than their 28.8 million barrels limit, Khelil said. Oil has fallen 30 percent from a record $147.27 a barrel on July 11 as high prices and slowing global economic growth reduced demand for fuels.

``It's definitely a defensive measure to keep prices above $100,'' said Jonathan Kornafel, a director for Asia at Hudson Capital Energy. ``They don't want to see us go back to $140 or $150 but they want us over $100. It's a bit of a shock to the market and that's why we're up.''

Crude oil for October delivery climbed as much as $1.41, or 1.4 percent, to $104.67 a barrel on the New York Mercantile Exchange and traded at $104.62 at 11:45 a.m. Singapore time. The contract had fallen as much as $1.20, or 1.2 percent, to $102.06 a barrel prior to the OPEC announcement.

Crude in New York yesterday reached its lowest level since April 2 while Brent oil traded in London fell as low as $99 a barrel. Demand for fuels in the U.S., the world's largest oil consumer, has declined this year because of the higher prices. Traders have also become more concerned that a global economic slowdown will reduce demand for commodities including fuels.

``The current price is due to slower demand not oversupply,'' said Tetsu Emori, a fund manager with Astmax Ltd. in Tokyo. ``The oversupply is a result and not a reason for lower prices. This is an adjustment of supply and demand only. It will not make the market tight as a result.''

OPEC Sentiment

Brent crude oil for October settlement rose as much as $1.40, or 1.4 percent, to $101.74 a barrel. It was at $101.73 a barrel at 11:46 a.m. Singapore time. The contract earlier fell as low as $98.89 a barrel.

OPEC noted that a declining global economy and resultant falloff in oil demand along with more crude supply and the gains in the U.S. dollar had lowered prices. This means ``a shift in market sentiment causing downside risks,'' according to their statement after the meeting.

``Since the market is oversupplied, the conference agreed to abide by September 2007 production allocation (adjusted to include new members Angola and Ecuador and excluding Indonesia and Iraq) totaling 28.8 million barrels a day,'' OPEC said. ``Levels with which members committed to strictly comply.''

OPEC's quota for 12 members including Indonesia had been 29.673 million barrels a day. Indonesia's target had been 865,000 barrels a day, according to Bloomberg data.

OPEC members have increased production this year as Saudi Arabia, the world's largest producer, sold more barrels to balance shortfalls elsewhere and slake the developing world's growing thirst for crude. That's taken output above the group's agreed targets.

Asian Stocks Drop for Second Day, Led by Materials Producers

Sept. 10 (Bloomberg) -- Asian stocks fell for a second day, led by materials and shipping companies, after metals prices declined and cargo rates slumped on concern slowing global growth will curb demand for resources.

BHP Billiton Ltd., the world's largest mining company, and Mitsubishi Corp. tumbled more than 2 percent. China Cosco Holdings Co., the world's largest operator of dry-bulk ships, tumbled 9.1 percent. Macquarie Group Ltd. slumped 4.5 percent after Lehman Brothers Holdings Inc.'s talks to sell a stake to Korea Development Bank broke down.

``This is not a good time to make new investments in risky assets like stocks,'' said Hiroshi Morikawa, senior strategist at Japan's MU Investments Co., which manages about $14 billion. ``I will keep my money in cash or bonds because of the uncertainties in the global economy. I prefer to stay in a safe harbor.''

The MSCI Asia Pacific Index fell 0.7 percent to 117.88 as of 11:37 a.m. in Tokyo, extending yesterday's 2.2 percent loss. Materials and industrial stocks accounted for more than half of today's decline.

The Asian benchmark has tumbled 25 percent in 2008 as global financial companies posted losses in excess of $500 billion on a credit contraction.

Japan's Nikkei 225 Stock Average lost 1.1 percent to 12,269.54. China's CSI 300 Index jumped 1.9 percent, erasing earlier losses, after inflation cooled last month to the slowest pace in a year. All other regional benchmark indexes declined apart from Taiwan.

Metals Decline

U.S. stocks slumped yesterday, with the Standard & Poor's 500 Index falling 3.4 percent, the most since February 2007. In the previous session, the measure gained the most in a month after the government's takeover of Fannie Mae and Freddie Mac. S&P 500 futures were up 0.4 percent recently.

An index of materials producers fell 2.9 percent to the lowest since October 2006. BHP dropped 4.5 percent to A$34.42 in Sydney, the lowest since March 25. Korea Zinc Co., the world's second-biggest zinc refiner, retreated 3.3 percent to 116,500 won in Seoul. Mitsubishi Corp., a Japanese trading company that gets half its profit from commodities, slipped 2.5 percent to 2,525 yen, the lowest since Jan. 24.

A measure of six metals traded on the London Metal Exchange, including zinc, lost 2 percent to 3,272.8 yesterday, the lowest since June 27, 2006.

China Cosco plunged 9.1 percent to HK$10.64, extending yesterday's 7.6 percent decline. Mitsui O.S.K. Lines Ltd., Japan's largest operator of iron-ore ships, fell 2 percent to 1,058 yen.

Shipping Rates

The Baltic Dry Index, a measure of commodity-shipping costs, yesterday tumbled to its lowest in 15 months. The measure has plunged more than 50 percent from its May 20 record.

Neptune Orient Lines Ltd., operator of Southeast Asia's largest container line, lost 4.3 percent to S$2.03 in Singapore, the lowest since November 2006.

Signs of a slowing global economy have damped demand for commodities. The U.K. economy is contracting for the first time in at least a decade, the National Institute for Economic and Social Research said today. The group's clients include the Bank of England and the U.K. Treasury.

``It's hard to tell at the moment just how deep the global economic downturn is going to get,'' said Hideo Arimura, who overseas the equivalent $1.9 billion at Mizuho Asset Management Co. in Tokyo. ``Europe is in the most precarious position and its weakness is going to be a drag for other economies.''

Macquarie, Australia's biggest securities firm, slid 4.5 percent to A$42.79. Babcock & Brown Ltd., an Australian manager of infrastructure assets, lost 4.6 percent to A$2.26.

Hynix Rises

Lehman has been negotiating with potential investors about obtaining a capital infusion and selling devalued mortgage assets that contributed to the firm's $2.8 billion loss last quarter. S&P warned yesterday it may cut Lehman's credit ratings, saying it believes the company may report a ``substantial'' third- quarter loss.

``People worry that if Lehman is like that, how about the others?'' said Pankaj Kumar, who manages about $460 million as chief investment officer at Kurnia Insurans Bhd. in Petaling Jaya, outside Kuala Lumpur. ``There could be more. That definitely shakes confidence in the market.''

Lehman said it will announce third-quarter results and ``key strategic initiatives'' today in the U.S., a week earlier than planned.

Hynix Semiconductor Inc., the world's second-largest computer-memory maker, added 4.6 percent to 19,450 won in Seoul. The company said today it will cut output of NAND flash chips by as much as 30 percent this month after a glut drove down prices. Separately, main creditor Korea Exchange Bank said yesterday it will ask other banks to revive talks on selling their combined 36 percent controlling stake in Hynix.

Down the Rabbit Hole

by Peter Schiff

In recent months, investors have been unjustly chastised for their lack of consistency. In truth, they have an unblemished record of drawing the wrong conclusions. Last week's 2nd quarter GDP report provides the freshest evidence of market cluelessness.

In its report, the Commerce Department stunned economy watchers by showing a 3.3% annualized increase in 2nd Quarter GDP. The robust growth apparently wrong-footed those expecting further recessionary signals, lent further strength to the current dollar rally, and encouraged previously cautious investors to take another look at U.S. stocks. The strong number also bolstered claims by the Bush administration and the McCain campaign that a recession is primarily a psychological phenomenon. These conclusions would be at least quasi-logical if they were not based on a complete misreading of the report.

Without raising an eyebrow on Wall Street or in the press, the GDP deflator, used in the report to downwardly adjust GDP to account for inflation, was shown at just 1.2% annualized.... the lowest deflator in ten years. In other words, to arrive at a 3.3% growth rate, the government assumed that inflation is running at a ten-year low! In contrast, the latest reading on consumer prices (CPI) in the second quarter shows year-on-year inflation running at a 5.6% rate, a seventeen-year high! In fact, for the second quarter, the same time period measured by the GDP deflator, prices actually rose at an even faster pace of 8.0% annualized. How can it be that inflation is simultaneously running at a seventeen-year high and a ten-year low? Welcome to the Alice in Wonderland world of government statistics.

You would think that this statistical bombshell would raise the hackles of the press. Think again. Not only did the hawk-eyed media completely miss the story last week, they have totally ignored our subsequent attempts to show them the light (with the exception of the N.Y. Post's John Crudele – who has long suspected a ruse). Although none of the reporters we spoke with could explain why inflation could run at a 10 year low and a 17 year high at the same time, they did not deem the anomaly sufficiently noteworthy. Having been ignored by reporters, I then tried the opinion pages. Unfortunately the piece that we prepared on the subject was rejected this week by all the leading national newspapers.

Reporter Michael Mandel did note the head scratcher on a Businessweek blog posting last Friday. As a partial explanation he pointed out the CPI measures the prices of what we buy, and the GDP deflator measures the prices of what we make. Although this certainly sheds some light, it offers no real explanation. Excluding imports and exports, both measures are determined by the same forces, and should move in relative harmony. If anything, the costs of what we make should be outpacing the costs of what we buy. Producer prices are now rising faster than consumer prices (the latest annual reading of the Producer Price Index 'PPI' being 13.2% annualized from the 2nd quarter), which helps explain why corporate profits have fallen drastically. In addition, from July 2007 through July 2008 (the latest data available) import and export prices have risen 21.6% and 10.2% respectively. In other words, no matter what numbers you use, the 1.2% GDP deflator simply doesn't add up.

I have often argued that government statics are dubious, particularly those related to inflation. But here is an example where they are not even consistent! If we simply use second quarter CPI to adjust nominal second quarter GDP for inflation, the number would have registered a 3.5% annualized decline.

Such horrific GDP numbers are much more consistent with the anecdotal recession evidence that Wall Street and Washington want us to ignore (confirmed by today's weak jobs report which included the unemployment rate spiking to 6.1%, a five-year high). However, with Orwellian propaganda, our government fabricates GDP growth out of thin air without the smoke and mirrors traditionally required for such an elaborate illusion. All that is required is to put out ludicrous statistics and hope no one notices. Given that this strategy appears to be working, expect future government numbers to get even more outrageous. After all, if they can get away with this, they can likely get away with anything.

Investors relying on this data and reacting to the global economic slowdown by buying dollars and other U.S. based assets while selling gold, commodities, and foreign assets, are jumping out of the frying pan right into the fire. My guess is that it will not be much longer before they feel the heat.

For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read Peter Schiff's book "Crash Proof: How to Profit from the Coming Economic Collapse." Click here to order a copy today.

More importantly, don't wait for reality to set in. Protect your wealth and preserve your purchasing power before it's too late. Discover the best way to buy gold at www.goldyoucanfold.com, download our free research report on the powerful case for investing in foreign equities available at www.researchreportone.com, and subscribe to our free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp.

Peter Schiff C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.

Mr. Schiff is one of the few non-biased investment advisors (not committed solely to the short side of the market) to have correctly called the current bear market before it began and to have positioned his clients accordingly. As a result of his accurate forecasts on the U.S. stock market, commodities, gold and the dollar, he is becoming increasingly more renowned. He has been quoted in many of the nations leading newspapers, including The Wall Street Journal, Barron's, Investor's Business Daily, The Financial Times, The New York Times, The Los Angeles Times, The Washington Post, The Chicago Tribune, The Dallas Morning News, The Miami Herald, The San Francisco Chronicle, The Atlanta Journal-Constitution, The Arizona Republic, The Philadelphia Inquirer, and the Christian Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg. In addition, his views are frequently quoted locally in the Orange County Register.

Mr. Schiff began his investment career as a financial consultant with Shearson Lehman Brothers, after having earned a degree in finance and accounting from U.C. Berkley in 1987. A financial professional for seventeen years he joined Euro Pacific in 1996 and has served as its President since January 2000. An expert on money, economic theory, and international investing, he is a highly recommended broker by many of the nation's financial newsletters and advisory services.

Paulsons Quick Draw
by Peter Schiff

Treasury Secretary Henry Paulson, the man who said that subprime was contained and that the Bazooka in his pocket would never be used, now assures us that the bailout of Fannie Mae and Freddie Mac will be costless to taxpayers. Despite the near euphoria that the plan has sparked on Wall Street, the move will go down in history as the biggest policy blunder of all time, and will be credited as a pivotal point in the financial collapse of the American economy. The ultimate cost to Unites States citizens will be in the range of hundreds of billions of dollars, perhaps more.

The original idea that gave birth to Freddie and Fannie, which is to make housing more affordable to average Americans, should now be seen as farcical. Their new goal is to keep housing prices high. Absent Freddie and Fannie, housing prices would fall sharply and the mortgage market would stabilize. Americans would once again be able to buy affordable houses with mortgages they could actually repay - just like their grandparents did. Instead they will keep overpaying for houses, burdening themselves with excessive payments in the process, and ultimately sticking taxpayers with the bill when they default.

In contrast to Paulson's continuous misreading of the market, I have consistently predicted the failure of Freddie and Fannie. I did so in my book Crash Proof, and in numerous speeches, commentaries and television appearances. If you have not yet done so, click here to watch these eight YouTube clips of my presentation back in 2006 to a convention of mortgage bankers. I also was quick to point out that Paulson's Bazooka would not remain holstered for long. See the following two commentaries "Armed and Dangerous" and "Congress Taps Paulson's Helmet" available here.

There is absolutely no substance to Paulson's insistence that based on the government's first claim on the future profits of Fannie and Freddie, the plan offers protection for taxpayers. There will be no future profits, just more heavy losses. Americans will now have unlimited ability to continue to overpay for houses and commit to mortgages they can't afford. In fact, the plan insures that eventual public sector losses will vastly exceed those that would have befallen the private sector in a free-market resolution.

Paulson claims that his goal is to stabilize the mortgage market. But the best way to do so would be to allow housing prices to fall to a market clearing level. As long as home prices remain artificially high, the risks of mortgage lending will keep credit tight, and the high costs of mortgage payments will keep potential buyers on the side-lines. With private lenders justly cautious, the government intends to hold open the lending spigots, without the pesky concerns over losses or financial risk. The hope is that the new lending will prevent home prices from falling further. It won't work. The government "solution" will simply delay the fall of artificially high home valuations and temporarily preserve the illusion of prosperity.

In order to preserve current home prices, the government will be forced to maintain the lax lending standards that got us into this mess in the first place. Since all the losses will now be borne by taxpayers, those lax standards will be much more problematic. The moral hazard that existed prior to this bailout has become that much more hazardous. Every mortgage now insured by Fannie and Freddie is the equivalent of a U.S. Treasury bond. This allows anyone to borrow on the full faith and credit of the U.S. government so long has the money is used to buy a house. In addition, mortgage lending will now be a government function, run with Post Office-like efficiency.

Of course the biggest collateral damage caused by Paulson's bazooka is the large hole ripped through the already tattered U.S. Constitution. If the government can do this, does anyone believe there is anything it can't do? In effect the Federal government now has absolute power to corrupt absolutely.

Hong Kong Votes for Democracy

FROM TODAY'S WALL STREET JOURNAL ASIA
September 9, 2008

Hong Kongers have suffered one delay after another on their path to full democracy since the territory's return to China in 1997. But that hasn't snuffed out their democratic spirit. Witness the results of Sunday's legislative elections.

Pro-democracy parties won 23 seats in the 60-member Legislative Council elections. That's down from 25 after the last election in 2004. But that's not the number that matters. Half of the legislature is appointed by special interest groups loyal to Beijing. The other half is directly elected by the people. In those seats, the democrats won 19 of 30, gaining a seat from the 2004 results. The democrats' losses came only from the ranks of special-interest legislators.

The result maintains the crucial veto pro-democracy parties have wielded over constitutional reforms by denying the pro-Beijing parties a 40-seat supermajority. This won't force Government House to push ahead with democracy faster, but it will keep Beijing from pushing any antidemocratic electoral "reforms."

Within the democratic movement, this election also marks a changing of the guard of sorts. Its best-known figureheads have left -- Democratic Party founder Martin Lee and former bureaucrat Anson Chan, both of whom announced their retirements before the election. Sunday's results thus give a mandate to a new generation of democratic voices in the legislature, like Kam Nai-wai, a 47-year-old social worker and member of the Democratic Party just elected to represent Hong Kong Island.

The result is also a slap in the face to the Democratic Alliance for the Betterment and Progress of Hong Kong (DAB), the largest pro-Beijing group that campaigned for seats. The DAB is better funded and better organized than the pro-democracy crowd. In the run-up to Sunday's vote, the DAB blanketed the territory with advertisements. Chief Executive Donald Tsang did his part, too, rolling out a package of largesse including expanded electricity discounts, and hosting a star tour by China's Olympic athletes. Yet those efforts yielded only eight directly elected seats.

Voters clearly were frustrated with the government's economic record. Ahead of Sunday's polls, a Hong Kong University Public Opinion Programme poll found 87% of voters said their decision would be driven by "livelihood" issues like housing and education, while 77% said they were "focusing" on economic policies. Little wonder: inflation is running 6.3% and GDP growth slowed to 4.2% in the second quarter, from 7.3% in the first.

On their face, the pro-Beijing and democratic policy platforms weren't that far apart. Unfortunately, both favor imposing a minimum wage and enacting a competition law. The key difference was that democrats also campaigned on holding Mr. Tsang's administration accountable for its perceived policy blunders. This suggests that Hong Kongers understand better than some of their leaders the relationship between democracy and prosperity.

Skeptics will note that turnout, at about 45%, was 10 percentage points lower than in the last general election, in 2004. But Hong Kong's turnout was still high by the standards of some other democracies. In 2006 in the U.S., when a very unpopular executive faced a legislative election, only 41% of voters turned out. So it's hard to argue that Hong Kongers are not interested in democracy now.

Sunday's election is another reminder that the territory deserves a democratic system worthy of its voters.

The Hunt for Sarah October

City slickers invade Wasilla
September 9, 2008

Democrats understand Sarah Palin is a formidable political force who has upset the Obama victory plan. The latest Washington Post/ABC Poll shows John McCain taking a 12-point lead over Barack Obama among white women, a reversal of Mr. Obama's eight-point lead last month.

It's no surprise, then, that Democrats have airdropped a mini-army of 30 lawyers, investigators and opposition researchers into Anchorage, the state capital Juneau and Mrs. Palin's hometown of Wasilla to dig into her record and background. My sources report the first wave arrived in Anchorage less than 24 hours after John McCain selected her on August 29.

The main area of interest to the Democratic SWAT team is Mrs. Palin's dismissal in July of her public safety commissioner. Mrs. Palin says he was fired for cause. Her critics claim he was fired because he wouldn't bend to pressure to get rid of a state trooper, Mike Wooten, who had been involved in a bitter divorce battle with Mrs. Palin's sister. Mr. Wooten is certainly a colorful character. He served a five-day suspension after the Palin family filed a complaint against him alleging he had threatened Mrs. Palin's father. They also accused him of using a Taser on his 10-year-old stepson, drinking in his patrol car and illegally shooting a moose.

Mrs. Palin will return to Alaska for the first time in nearly two weeks on Wednesday night, when she is scheduled to arrive in Fairbanks. Local Republicans will hold a "Welcome Home" rally for her. You can bet some of the Democratic opposition research contingent will be in the audience taking notes. They'll be the ones arriving in rental cars and wearing fancy dress shoes from back east.

-- John Fund

We'll Protect Taxpayers
From More Bailouts

By JOHN MCCAIN and SARAH PALIN

The bailout of Fannie Mae and Freddie Mac is another outrageous, but sadly necessary, step for these two institutions. Given the long-term mismanagement and flawed structure of these two companies, this was the only short-term alternative for ensuring that hard-working Americans have access to affordable mortgages during this difficult economic period.

We are strong advocates for the permanent reform of Fannie and Freddie. For years, Congress failed to act and it is deeply troubling that what we are now seeing is an exercise in crisis management rather than sound planning, and at great cost to taxpayers.

We promise the American people that our administration will be different. We have long records of standing up to special interests and providing the leadership to change government and make it more accountable to the American taxpayer. In our administration, every agency and department will undergo rigorous oversight and review. We will require the highest standards of accounting, reporting and transparency ever demanded in government.

Enduring reform of Fannie and Freddie is a key first step. We will make sure that they are permanently restructured and downsized, and no longer use taxpayer backing to serve lobbyists, management, boards and shareholders.

Treasury has broadly followed the McCain plan, outlined months ago, and gets at the short-term heart of the problem. That plan reinforces the federal commitment to meet our obligations and get this mess behind us. It replaces management and board members. It requires that shareholders take losses first. It puts taxpayers first in line for any repayments. And it terminates future lobbying, which was one of the primary contributors to this great debacle.

Along with the commitment of taxpayers' dollars, we should make market reforms to help ensure that we do not face this problem again. We will make sure the marketplace understands its obligations. Homeowners must be able to understand the terms and obligations of their mortgages. In return, they have an obligation to provide truthful financial information, and should be subject to penalty if they do not. Policies must be in place to ensure that homeowners provide a responsible down payment of equity in the initial purchase of a loan. In the future, Fannie, Freddie or any government organization should never insure a loan when the homeowner doesn't have enough of his or her own capital in the investment.

Lenders who initiate loans will be held accountable for the quality and performance of those loans, and strict standards must be required in the lending process. Every lender must be required to meet the highest standards of ethical behavior, with recourse if they do not perform.

Reforms are necessary now to make mortgage lending and banking organizations more transparent. We will require greater disclosure, so that complex derivative instruments and excessive leverage can't put the marketplace, and the financial security of your home, at risk.

We will push the nation's top mortgage lenders to provide maximum support to help cash-strapped, but credit-worthy customers. Lenders should do everything possible to keep families in their homes and business growing.

Fixing Fannie and Freddie, and reforming our mortgage and financial markets, is critical to getting the housing market and the entire economy moving again. A great deal of the savings and wealth of American families is wrapped up in the value of their homes. A house has traditionally been the wealth-building course to retirement. The housing industry employs millions of Americans. One of us, John McCain, said over two years ago, "If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose."

Fannie and Freddie's lobbyists succeeded and Congress failed. Under our administration this will not happen again.

In the first 100 days of our administration, we will look at every agency and department and expenditure of the federal government and ask this simple question: Is it serving the needs of the taxpayer? If it is not, we will reform it or shut it down, and we will spend money only on what is truly in the interest of the American people.

Mr. McCain and Mrs. Palin are, respectively, the Republican candidates for president and vice president.

The Perils of U.S. Protectionism

Democratization and Its Discontents

"Yes, Leezza, Leezza, Leezza," leched Libya's Moammar Gadhafi last week on the eve of his meeting with the U.S. Secretary of State in Tripoli. "I love her very much."

Posterity will surely not record whether the dictator's feelings were reciprocated. But it will remember that Ms. Rice, who began her tenure as secretary with a ringing call for freedom and democracy, is ending it on a more genial note when it comes to the world's despots.

AP

Tripoli, Libya, Sept. 5, 2008.

"For 60 years," she said in Cairo in June 2005, "the United States pursued stability at the expense of democracy in the Middle East -- and we achieved neither." Yet the U.S. rapprochement with Libya is nothing if not the triumph of the stability agenda over the freedom one. Just ask Libyan democracy activist Fathi El-Jahmi (on whose behalf Sen. Joe Biden has made honorable exertions), assuming you can find him in whatever dark cell Mr. Gadhafi has him.

But let's give Ms. Rice her due. Her return to the realpolitik of onetime mentor Brent Scowcroft is earning rave reviews. In Time magazine, reporter Scott Macleod lauded her visit to Libya as "an unqualified success" and "an example of how violent disputes in the troubled region can be settled through diplomacy rather than war." Former Clinton administration official James Rubin is over the moon over Ms. Rice's reported efforts to establish a U.S. interests section in Tehran. Her push to bring about an Israeli-Palestinian peace deal is also being lauded, as is her diplomatic outreach to Syria and North Korea.

Meanwhile, Washington is getting what so far seems a crummy return on its pro-democracy investments. The Bush administration made a notable push for Palestinian democracy and wound up electing Hamas, which will almost certainly win next year's presidential election should it choose to contest it. It pushed the Syrians out of Lebanon, only to get a weak and divided democratic government that crumbled in the face of Hezbollah's (and Syria's) violent provocations.

It looked on as Pakistan democratized its way out of Pervez Musharraf's autocratic -- and relatively clean and competent -- hands and into Asif Ali Zardari's dirtier and clumsier ones. It supported Georgia's Mikheil Saakashvili as he blundered his way into a war with neighboring Russia. In Iraq, it has discovered that Prime Minister Nouri al-Maliki is a man in the mold of Charles de Gaulle: firm, astute, nationalistic -- and not particularly eager to be seen as America's man, much less George W. Bush's.

So is the freedom agenda a bust? I think not. As in life, so too in foreign policy: The options before us are rarely marked "good" and "bad."

Would the Palestinian Authority be a more peaceable kingdom if a "secular" tyrant like Yasser Arafat were in charge? Was Lebanon better off when Syria terrorized its citizens (and supported Hezbollah) openly, without a murmur of opposition? Would America's influence in Pakistan have been enhanced had we stood in the way of the groundswell of popular opposition to Gen. Musharraf after he began rounding up lawyers, judges and civil-rights activists? Would Georgians have been better off under a Belarus-style regime that did the Kremlin's bidding automatically?

And could the administration have better fought the insurgency in Iraq or defended its political position at home if it had done so in the service of a puppet or military Iraqi government? Previous administrations tried something similar with South Vietnam's Nguyen van Thieu, not to the best effect.

This isn't to say that policies that promote democratization are always and everywhere the better option: The world would have been better off if Jimmy Carter had backed the autocratic Shah instead of acquiescing to the totalitarian Ayatollah. Nor is it to deny that democratization is a fraught, dangerous and reversible process.

On the other hand, a policy that encourages democratic openings wherever they are feasible is at least potentially sustainable, whereas policies biased toward maintaining autocratic stability are invariably unsustainable.

Time will tell whether Iraq is able to maintain its democracy. But it stands a better chance of survival than Egypt's pressure-cooker regime, the Saudi gerontocracy, Iran's theocracy or Libya's cult-of-personality state. Time will also tell whether Georgian democracy will be able to survive the Russian onslaught. But that onslaught is a potent reminder of the neocon notion that the internal character of authoritarian states really does predict their foreign policies.

So let's grant that in normalizing relations with a WMD-free Libya, Ms. Rice has chalked up one of the few wins of her desultory tenure -- so long as we also grant that turning one dictator would never have happened had we not turned out another.

Japan's economy

Down but not out

Japan could yet outperform the other big rich economies over the next year

THE surprise resignation of Japan’s prime minister, Yasuo Fukuda, has once again left the world’s second-largest economy rudderless—just as it seems to be drifting dangerously towards the rocks. Although America is the centre of the world’s financial troubles, Japan’s economy appears to have been hit harder: its GDP fell sharply in the second quarter, whereas America’s continued to expand. Indeed, many economists expect Japan’s economy to shrink again in the three months to September, which on the rule of thumb of two consecutive quarters of decline, would imply a recession. You might conclude that without radical reform Japan will continue to underperform. However, a more thorough health check suggests that Japan’s economy is actually in better shape than it looks, and its downturn may be shorter and shallower than those in America and most European economies could be.

Three days before Mr Fukuda quit, fears that the economy was sinking into another deep recession panicked the government into announcing a modest stimulus package of tax cuts and financial assistance for transport and construction industries, and for smaller firms. Even if these measures are carried out, most economists do not think it would do much to revive the economy. Some politicians would like a big increase in public spending, but the government has promised to eliminate its primary budget deficit (ie, before interest payments) by 2011-12 in order to reduce public-sector debt of 170% of GDP—the largest among the big rich economies.

The government’s balance sheet may seem dire, but the private sector’s looks healthier than for many years, because Japan has avoided the economic and financial imbalances that threaten many economies in the West. Unlike America and parts of Europe, notably Britain, Japan is not experiencing a credit crunch and house prices are not collapsing. Consumer and corporate finances are also generally in better shape.

Japanese financial institutions’ losses on securities linked to American subprime mortgages so far amount to just $17 billion, out of worldwide losses of $500 billion. As a result, most banks can still lend, except to property developers, some of which rely heavily on funding from abroad and from small regional banks. Several of them have gone bust in the past few months. More generally, however, Japanese house prices are unlikely to crumble. After its housing bubble burst in the 1990s, the market has not inflated again.

The biggest contrast with America and Britain is that Japanese households have reduced their debt from 71% of GDP in 2000 to 63% this year, according to Goldman Sachs. This is much lower than debt ratios of around 100% in both America and Britain, where borrowing has exploded over the past decade (see chart). The only other G7 economy where consumer debt has declined is Germany, which has also avoided a housing bubble.

Japanese companies have trimmed their debts even more dramatically, to 78% of GDP from 130% in 1991. The level is now well below where it was before the 1980s bubble, though higher than corporate America’s debt of less than 50% of GDP. (American firms have traditionally relied more on equity financing.) On the other hand, corporate debt has expanded rapidly in the European Union.

Heavy debts, falling property prices and a shortage of new credit are a lethal cocktail, which could depress economic growth in America and parts of Europe for several years—as Japan itself found out in the 1990s. Today Japan’s economy is much less burdened by debt and so likely to recover more quickly.

Another reason why the downturn in Japan could be fairly mild is that almost half of Japan’s exports go to other buoyant Asian economies. Exports had been the main force behind Japan’s recovery before they slowed this year. Shipments to America and to Europe have fallen, but demand from the rest of Asia remains strong. In July, for the first time, Japan exported more to China than to America.

Japan’s long-term growth rate has undoubtedly been strangled by the lack of reform. Yet its economy is now in better shape than for many years. Japan’s GDP is likely to grow faster than both America’s and the euro area’s over the next year. If so, 2009 will be the fourth year running that Japan’s GDP per head shows the biggest increase of the three. And that is not only because its population is shrinking.

Russia and the West

A deal, for now

Europe shores up the Russian-Georgian ceasefire agreement

HUMILIATION avoided, but hardly a triumph: that is the upshot of President Nicolas Sarkozy’s talks in Moscow on Monday September 8th, where he tried to get the Kremlin to implement in full a French-brokered ceasefire that ended Russia’s war with Georgia.

After sometimes stormy talks, Mr Sarkozy, accompanied by the European Union’s nominal foreign-policy chief, Javier Solana, and the EU commission’s president, José Manuel Barroso, gained agreement on the withdrawal of Russian troops from a buffer zone established around the two breakaway regions of South Ossetia and Abkhazia. Russia (but so far almost nobody else) has recognised both places as independent states.

Russian forces will leave positions around the port of Poti within a week, and pull back from the rest of the buffer zone ten days after EU monitors are deployed, which must be by October 1st. Yet that is pretty much what Mr Sarkozy thought he had gained in the first ceasefire agreement, which envisaged (at least in Western eyes) troops from both sides moving back promptly to their pre-conflict positions.

Mr Sarkozy said that the deal, if honoured, would allow the resumption, presumably in October, of talks between the EU and Russia on a new partnership agreement. The decision of an emergency European summit was to suspend these talks amid unprecedented displeasure with Russia for its invasion of Georgia and recognition of the breakaway regions.

Yet the coming weeks offer plenty of scope for quibbling and foot-dragging. Russia has repeatedly accused Georgia of breaking the ceasefire agreement: that could be one pretext. Another could be any signs of American help to rebuild the shattered remnants of the Georgian army—which the Kremlin refers to hyperbolically as “Georgia’s military machine”. Russia also wants the Georgian leadership to sign a binding agreement renouncing the use of force to recover the lost territories. The EU says it will guarantee this. It also wants Mikheil Saakashvili, Georgia’s president, to stand trial for war crimes. It is unclear whether a 200-strong EU force will be able to patrol inside the breakaway regions.

Blame for the muddle rests partly with France, currently in charge of the EU. Mr Sarkozy allowed two different versions of the vaguely worded ceasefire agreement to circulate, with ambiguous translations on a key issue: whether Russia is allowed to provide security “in” the breakaway regions, or “for” them.

The latest agreement also allows Russia to maintain many more troops in South Ossetia and Abkhazia than before the conflict. Western diplomats say that insisting on a reduction to pre-war levels is unrealistic. None of that is much comfort for the Georgian leadership, which is coping with tens of thousands of refugees and a nose-diving economy. Russian pressure for his departure may have shored up Mr Saakashvili’s position for now, but behind the scenes Georgian politicians are manoeuvring to replace him.

The worst east-west row for more than two decades may have stopped hotting up, but it is not cooling off much. Russia is sending a flotilla headed by one of its largest warships, Peter the Great, a nuclear-powered cruiser, to the Caribbean for joint manoeuvres with Venezuela, America’s most pungent adversary in the region. That follows the deployment of a handful of American naval ships to deliver humanitarian aid to Georgia. America has suspended a deal with Russia that would have allowed companies from both countries to invest in each other’s nuclear industry.

Russia may be betting that Europe and America cannot stay focused on Georgia for long. Russian help is needed on a range of other global issues, from Afghanistan to Iran. The EU and NATO are both deeply divided on Russia, with countries such as Italy loudly opposing sanctions of any kind, and others such as Germany highly mindful of Russia’s role as an energy supplier. A more hawkish camp, including Britain, Sweden, Poland and the Baltic states, want a fundamental rethink of relations with Russia. But even proponents of that admit that the costs will be high, and the benefits distant.

Fannie Mae, Freddie `House of Cards' Prompts Takeover (Update1)

Sept. 9 (Bloomberg) -- Fannie Mae and Freddie Mac used accounting rules that created a ``house of cards'' as the housing market descended into its worst slump since the Great Depression.

While the two largest mortgage-finance companies met regulatory requirements for their capital, reviews by the Treasury, the Federal Housing Finance Agency and the Federal Reserve found they probably wouldn't weather the highest delinquency rates on record, lawmakers and regulators said.

``Once they got someone looking closely at Fannie and Freddie's books, they realized there just wasn't adequate capital there,'' U.S. Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. ``They found out they had a house of cards.''

Treasury Secretary Henry Paulson and FHFA Director James Lockhart seized control of Fannie and Freddie less than a month after Lockhart, whose job is to oversee the companies, declared them ``adequately capitalized'' under law. The discrepancy highlights the flaws in legislation and in the regulatory oversight of Fannie and Freddie that didn't demand they keep more assets as a cushion against losses, according to Joshua Rosner, an analyst with Graham Fisher & Co. in New York.

``Fannie and Freddie's accounting during the housing crisis appears to have been more fantasy than reality,'' said Rosner, who first highlighted problems in 2003, before the two companies were forced to restate about $11.3 billion in earnings.

`Not Adequate'

Washington-based Fannie had $47 billion of regulatory capital as of June 30, about $9.5 billion above what FHFA required, according to company filings. McLean, Virginia-based Freddie's capital stood at $37.1 billion, a cushion of about $2.6 billion over FHFA's standard, filings show.

``They met the legal definition,'' Lockhart said in an interview with Bloomberg Television yesterday. ``As I have been telling lawmakers for a long time, that legal definition was not adequate.''

As their stock prices declined and yields on their debt rose to the highest in at least 10 years above benchmark rates, the FHFA saw ``big questions out there,'' Lockhart said.

``The issue is that the exposures are continuing and continuing to grow and it looked like in the future there were going to be significant issues and they were going to have capital problems,'' Lockhart said.

Lockhart said he brought in financial examiners for the Federal Reserve and the Office of the Comptroller of the Currency to help with a review of the companies' finances. Treasury also sought help from Morgan Stanley officials, who prepared a report after trawling through the accounts.

`Too Low'

After looking through the finances, Fed examiners deemed their capital reserves too low, Dallas Fed President Richard Fisher said yesterday.

``We concluded that the capital of these institutions was too low relative to their exposure,'' Fisher said in response to an audience question after a speech in Austin, Texas. Further, ``that capital in and of itself was of low quality.''

Fannie counted $20.6 billion in so-called deferred tax credits toward its $47 billion of regulatory capital as of June 30, according to company disclosures. Freddie applied $18.4 billion in deferred-tax assets toward its $37.1 billion in regulatory capital in the second quarter.

Fannie and Freddie have posted four straight quarterly net losses totaling a combined $14.9 billion and have said they anticipate more. The tax credits don't have any value unless the companies are generating profit.

`Not Even Real'

``That's not even real money,'' Shelby said.

Senator Christopher Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee responsible for oversight of the companies, said yesterday he plans to hold hearings on why the Bush administration didn't act sooner.

``Why weren't we doing more, why did we wait almost a year before there were any significant steps taken to try to deal with this problem?'' Dodd said in a Bloomberg Television interview. ``I have a lot of questions about where was the administration over the last eight years.''

Market Value

After more than eight years of debate, Congress passed a law in July expanding Lockhart's authority to raise capital requirements, curb growth and to take over the companies' operations in a conservatorship or liquidate their assets under receivership. The legislation also gave Paulson temporary power to inject unlimited sums of taxpayer money into the companies.

The companies just four years ago admitted to $11.3 billion in earnings misstatements that led to $525 million in federal fines, tighter regulatory controls and the ouster of the CEOs.

Paulson said he stepped in to prevent a collapse of the companies, protecting investors owning more than $5 trillion of Fannie and Freddie corporate debt and mortgage-backed securities while potentially sacrificing holders of the common and preferred stocks.

The companies yesterday lost the majority of their market value, with Fannie falling 90 percent to 73 cents in New York Stock Exchange composite trading, its lowest level since 1982. Freddie dropped 83 percent to 88 cents, the lowest since the regular common stock began trading 20 years ago.

The stocks rebounded in European trading today. Fannie rose 12 cents, or 16 percent, to 85 cents by 9:44 a.m. in Frankfurt, and Freddie gained 8 cents, or 9 percent, to 96 cents.

McCain May Privatize Fannie, Freddie; Obama Sees Federal Role

Sept. 9 (Bloomberg) -- John McCain and Barack Obama agree the Treasury needed to step in to rescue Fannie Mae and Freddie Mac. They disagree over how much the U.S. government should be involved in the housing market once the immediate crisis is past.

Republican Senator McCain of Arizona wants the government to take over the two agencies, split them up, and then exit the mortgage-finance business by selling them off. Democratic Senator Obama of Illinois is suggesting a more lasting federal involvement.

``The role of the U.S. government in the housing industry is in play,'' said Jim Leach, a former 15-term Republican congressman from Iowa who is now an Obama supporter. ``There are pragmatic and philosophical issues at stake.''

The differences between the two presidential candidates over the lenders mirror a broader philosophical divide over the part the government should play in the economy. McCain supports steep cuts in taxes and spending to promote growth. Obama, while backing some tax reductions, favors increased public investment to boost the economy and job growth.

Conservatorship

Treasury Secretary Henry Paulson and Federal Housing Finance Agency Director James Lockhart placed Fannie and Freddie in a government-operated conservatorship over the weekend, ousting their chief executives and eliminating their dividends.

McCain, 72, and Obama, 47, have both endorsed the Treasury rescue of the two firms as necessary given the fragile state of the housing market and economy. They were also sharply critical of the managements of the government-sponsored companies, which together own or guarantee almost half of U.S. home loans.

The candidates found less common ground on the mortgage giants' long-term fate, which Paulson, 62, said remained undetermined until at least after the November election.

``The new Congress and the next administration must decide what role government in general, and these entities in particular, should play in the housing market,'' he told reporters over the weekend.

Robert Litan, vice president for the Kansas City, Missouri- based Kauffman Foundation, said the next president faces three choices for dealing with Fannie and Freddie: retain the current public/private partnership in some form, nationalize the companies, or privatize them.

McCain Plan

McCain is clear on what he wants to do. He backs a solution put forward by former Federal Reserve Chairman and fellow Republican Alan Greenspan that would break the companies up and sell the pieces off.

McCain would ``get them completely off the taxpayers' back,'' Douglas Holtz-Eakin, McCain's chief economic adviser, said in an interview on Bloomberg Television yesterday.

He added though that the Republican nominee saw some role for government in ``making credit available to those who otherwise can't get a mortgage'' through the Federal Housing Administration and other agencies.

Obama has been more circumspect on what should be done once the crisis is over, while making clear that a return to the status quo that existed before the rescue is unacceptable.

``We must ensure that any plan clarifies the true public and private status of our housing policies,'' the Democrat said over the weekend. ``We have to make clear that in our market system investors can't be allowed to believe that, unlike working families, they can simply invest in a `heads they win, tails they don't lose' situation.''

`Hasty' and `Ideological'

Jason Furman, Obama's top economic adviser, attacked McCain's privatization plan as ``hasty'' and ``ideological.''

``These institutions do serve a lot of vital public functions for affordable housing that just aren't served right now by any other government institutions,'' he told Bloomberg Television in a separate interview yesterday.

Furman said the outcome would depend on ``disentangling'' the important roles that Fannie and Freddie perform that can't be replicated by the private sector from those functions that can be handled by the market.

``Both candidates agree that the current model doesn't work,'' said Daniel Clifton, head of policy research in Washington for Strategas Research Partners. ``They have different solutions based on their ideological bent.''

Democratic Congress

In any case, whoever wins the presidential race will have to get a plan through a Democratic-controlled Congress that has strongly supported Fannie Mae and Freddie Mac.

``You can't eliminate them,'' Connecticut lawmaker Chris Dodd, the chairman of the Senate Banking Committee, told Bloomberg Television yesterday. ``They have been a tremendous source of stability and strength'' for the housing market.

His counterpart in the House, Massachusetts Representative Barney Frank, who heads the Financial Services Committee, lauded Fannie and Freddie's ``vital role'' in a statement issued Sept. 6.

Charles Calomiris, chairman of Reston, Virginia-based Greater Financial Corp. and a long-time critic of the two firms, told Bloomberg Radio that Congress had persistently opposed overhauling the companies.

``McCain would be inclined toward a more radical solution, though Obama might have a better chance at a less radical solution,'' said Gerald O'Driscoll, a former vice president of the Federal Reserve Bank of Dallas and now a scholar at the Cato Institute in Washington. ``But both of them face a Democratic Congress that is very wedded to these two firms as they exist.''

Generals Behaving Badly

When Abraham Lincoln famously sent word to Gen. George McClellan that he'd like to "borrow" the army if the general wasn't planning on using it, the commander of Union forces likely did not take it kindly. McClellan, after all, was a man whose letters home referred to Lincoln as an "idiot," "a well-meaning baboon" and other colorful language.

AP

Gen. George Casey.

In the first few pages of "The War Within," Bob Woodward opens with another presidential remark that offended another wartime general. This time the recipient was the commander of U.S. forces in Iraq, Gen. George Casey. During a videoconference with Baghdad, the president said, "George, we're not playing for a tie. I want to make sure we all understand this." Gen. Casey, Mr. Woodward writes, took this as "an affront to his dignity that he would long remember."

Whether or not Gen. Casey long remembered, "The War Within" makes clear his disdain for his commander in chief. If the views and remarks attributed to Gen. Casey are not accurate, Mr. Woodward has done him a grave injustice. If they are accurate, they come as further evidence of the obstacles President George W. Bush had to overcome to get his commanders to start winning in Iraq.

Opening with Gen. Casey also says something about Mr. Woodward. There's a case, I suppose, for using the general who opposed the surge to open what is hailed as the definitive account of that surge (not to mention using Robert McNamara, the Defense secretary who helped lose Vietnam to end the book). Surely, however, that would be the same case for wrapping the definitive account of the strategy that brought Robert E. Lee to Appomattox around Gen. McClellan.

Gen. Casey, after all, was the commander who all along maintained that the solution in Iraq was for America to draw down its forces -- even after the bombing of the Golden Mosque in Samarra. He was the commander who later that year was given his own chance to secure Baghdad with Operations Together Forward I and II, and failed. Most of all, he is the commander who was wrong when the president was right to insist that Baghdad could be secured and al Qaeda dealt a harsh blow with more troops.

Gen. Casey's continued adherence to a failed strategy does not make him a dishonorable man. It does make him an odd choice to serve as the foundation for the charge that the president was out of touch with the war. As evidence, both the general and the journalist point to questions about how many of the enemy we were killing as a sign that "the president did not get it."

Then again, maybe it's Gen. Casey and Mr. Woodward who did not get it. The questions the president asked were driven by something everyone in the West Wing worried about. Every night for years, Americans tuning into the evening news were greeted by the same image from Iraq: a burning car or Humvee, accompanied by a fresh report about soldiers or Marines who'd been blown up by an improvised explosive device or suicide bomb.

Nor did these images exist in a vacuum. A media obsessed with body counts featured grim roll calls of the dead, marking each macabre "milestone" -- 1,500 war dead, 2,000 war dead -- along the way. In this context, was it really unreasonable for a president to ask his commander on the ground if we were fighting back, when it sure didn't look that way to the American people?

The same might be said of the one truly original take offered by Mr. Woodward. This is his curious assertion that it's not the surge that has produced the great reduction in violence in Iraq. The reduced violence, he says, is the result of the increased lethality of covert operations against terrorist leaders and operatives.

Which brings up two interesting points. First, we are led to find fault with a president allegedly obsessed with a "kill the bastards" approach to Iraq. But then we are asked to accept that the reason we're now seeing success in Iraq because we're . . . killing the bastards.

Second, the surge was a shift in mission, not simply an addition of five brigades. Until the surge, we had pursued a political solution, hoping that the answer to Iraq was the rise of a democratic government that would persuade Iraqis to come together for their future. The surge, by contrast, finally recognized the obvious: Until Iraqis started feeling safe in their own homes and neighborhoods, there would be no compromise or rebuilding.

Sophisticates have never liked Mr. Bush for his preference for words like "win" and "victory" to describe what America is trying to do in Iraq. And if Mr. Woodward's latest contribution is any clue, they'll never forgive him for doing something even worse: proving it can be done.

ObamaTax 3.0

The good news is that Barack Obama said on ABC Sunday that he might not go through with his plans to increase taxes.

The bad news is that the economy has to be mired in recession to avoid the largest tax increase in the nation's history.

Our check of the Dow Jones Factiva database suggests that other than viewers of ABC's "This Week," only three or four newspapers carried an account of Senator Obama's amended tax plan. While it's possible that the story of a deferred tax increase could shock the media into paralysis, we take it as an encouraging sign. The education of Barack Obama continues apace.

For the record, here is what he told ABC's George Stephanopoulos.

Mr. Stephanopoulos: "So even if we're in a recession next January, you come into office, you'll still go through with your tax increases?"

Senator Obama: "No, no, no, no, no. What I've said, George, is that even if we're still in a recession, I'm going to go through with my tax cuts. That's my priority."

Mr. Stephanopoulos: "But not the increases?"

Senator Obama: "I think we've got to take a look and see where the economy is. The economy is weak right now. The news with Freddie Mac and Fannie Mae, I think, along with the unemployment numbers indicates that we're fragile. I want to accelerate those tax cuts through a second stimulus package, get more money into the pockets of ordinary Americans, see if we can stabilize the housing market, and then we're going to have to reevaluate at the beginning of the year to see what kind of hole we're in."

* * *

Even individuals staring down the barrel of Mr. Obama's tax increases should not wish for an economic recession to give them a reprieve. The relevant point is that it was early last year, when the "Bush economy" was still humming, that Senator Obama first proposed pushing taxes sharply upward on "the wealthy," while giving what he calls "tax cuts" (actually they are credits, not rate reductions) to "the middle class."

At the time, Mr. Obama was the long shot in the Democratic Presidential sweepstakes, and it made some political sense to reassure the party's intensely liberal primary voters with class-war boilerplate on taxes.

Under ObamaTax 1.0, he would have repealed all the Bush tax cuts, lifted the cap on wages subject to the payroll tax, put the top marginal rate up to 39.8% and raised the rate on capital gains and dividends to at least 25% from 15% now. The official campaign line was that tax rates really don't matter to economic growth.

Summer arrived, the Clinton challenge was history and with the general election ahead came ObamaTax 2.0. It posited that the top rate on capital gains now would be 20%, described on this page August 14 by economic advisers Jason Furman and Austan Goolsbee as "almost a third lower than the rate President Reagan set in 1986." This was progress.

Now with the big vote less than 60 days off and John McCain pounding him as a tax-raiser and pulling ahead in some polls, the Democratic nominee has decided to release ObamaTax 3.0, the most interesting upgrade so far. If the economy is still weak in January, a President Obama might defer all of the planned increases.

Several interpretations of this shift are possible, none of which reflect badly on Senator Obama's political learning curve.

At the bloodless level of simply wishing to win, the Obama camp may have concluded that in the sprint to November it is a losing strategy to be the election's only doctrinaire tax raiser. A tight race tends to focus political minds, and none forget Walter Mondale's catastrophic promise in his 1984 acceptance speech: "Mr. Reagan will raise taxes, and so will I. He won't tell you. I just did."

Beyond this lies the economic reality of jacking up income, investment and payroll taxes on "the wealthy" amid a flat or falling economy. In the standard narrative, these taxpayers exist as fat cats atop hedge funds, banks and megacorporations. Let's toss into the vat the top-tier managers of Fannie Mae and Freddie Mac, the Beltway's own fat-cat sinecure.

The reality is that the creators of new jobs in the economy are more likely to be rising entrepreneurs or filers under Subchapter S, who typically pay taxes at individual rates. Hanging three or four tax millstones around their productive necks in January if the economy is weak will likely produce unimpressive growth and job numbers in the first year of the new Obama Presidency, and likely beyond. That in turn could drag down the Democrats in Congress who will get credit for voting these higher taxes into law.

Thus Mr. Obama's unambiguous answer Sunday to whether he'd insist on his tax increases if the economy is in an official recession: "No, no, no, no, no." It seems Mr. McCain is right that taxes do matter.

Mr. Obama's most ardent primary supporters may not like it, but we'll take the five "Nos" as evidence that Senator Obama may be learning the difference between liberal doctrine and sensible governance.

The GOP Should Kiss
Gay-Bashing Goodbye

By JAMES KIRCHICK

Political conventions are memorable not only for what the party grandees say, but for what they leave out. What was noticeably absent from last week's Republican gabfest? Gay-bashing.

This is not an insignificant development for Republicans. In 2004, gays featured prominently at the Republicans' convention and in their rhetoric. In February of that year, President George W. Bush announced his support for the Federal Marriage Amendment (FMA), which would have written discrimination into our country's founding document by stipulating that marriage can only occur between a man and a woman.

AP

Patrick Sammon, president of the Log Cabin Republicans.

"Because the union of a man and woman deserves an honored place in our society, I support the protection of marriage against activist judges," Mr. Bush declared from the podium at Madison Square Garden.

It would be unfair to ascribe bigoted impulses to everyone who supports such an amendment. After all, gay marriage is an unfamiliar concept and people are naturally resistant to change. But the rhetoric of those supporting the FMA often went above and beyond expressing concern for the state of a weakening social institution and depicted gays as a nefarious force from whose conjugations America had to be protected. Gays became the target of a divisive campaign aimed at stirring up the GOP's socially conservative base.

As disappointing as the GOP's 2004 campaign was in this regard, it didn't hold a candle to the party's 1992 convention. The most famous speech to occur in Houston that year was the prime-time address delivered by Patrick Buchanan on opening night. "Pitchfork Pat" had challenged George H.W. Bush for the Republican nomination and did surprisingly well for a candidate confronting a sitting president. His address that year is best remembered for his observation that "there is a religious war going on in our country for the soul of America . . . a cultural war, as critical to the kind of nation we will one day be as was the Cold War itself."

Mr. Buchanan made it clear that primary soldiers on the other, dark side of this "cultural war" were gay people. Telling the audience that while the "three million Americans who voted for me" disagreed with Mr. Bush on some issues, he declared that "we stand with him against the amoral idea that gay and lesbian couples should have the same standing in law as married men and women."

And while rightly criticizing the Democrats for barring the antiabortion Democratic governor of Pennsylvania Bill Casey from speaking at their convention that year, Mr. Buchanan went on to rail that "a militant leader of the homosexual rights movement could rise at that convention and exult: 'Bill Clinton and Al Gore represent the most pro-lesbian and pro-gay ticket in history.' And so they do."

Other speakers, most prominently Vice President Dan Quayle, joined Mr. Buchanan in denigrating gay people. "Americans try to raise their children to understand right and wrong -- only to be told that every so-called lifestyle alternative is morally equivalent. That is wrong," he told the assembled delegates.

The image that Republicans projected to voters was that of a fearful party looking bitterly toward the past. This was hardly an advertisement for the cheerful, optimistic conservatism of Ronald Reagan, whose convention speech -- his last major address to the nation -- was overshadowed by the divisive rhetoric coming from the likes of Messrs. Buchanan and Quayle.

So it was refreshing to see that gays were not part of the agenda this year. Indeed, the only speaker to make mention of them was the former Arkansas governor and Baptist preacher Mike Huckabee, and he did so only tangentially, stating that Mr. McCain "doesn't want to change the very definition of marriage from what it has always meant throughout recorded human history." (The same, of course, could be said of the supposedly gay-friendly Barack Obama, who also opposes marriage equality for gay couples).

The absence of antigay rhetoric has much to do with Mr. McCain; he is comfortable around gay people, and his old-fashioned sense of honor proscribes against making them pariahs for political gain. He also has a better record on gay issues than most of his Republican colleagues, having courageously stood up against his party by opposing the FMA.

Partly for that stand, he won the endorsement last week of the Log Cabin Republicans, a gay GOP group that declined to endorse Mr. Bush in 2004 over his demagoguing gay marriage. Steve Schmidt, Mr. McCain's senior strategist, spoke to Log Cabin on the last day of the convention, informing them that "my sister and her partner are an important part of my life and our children's life," and that "I admire your group and your organization and I encourage you to keep fighting for what you believe in because the day is going to come."

Republicans might also have noticed the opinions of their own party members and realized that attacking the "gay agenda" would prove unpopular. On the eve of the convention, a New York Times/CBS News poll reported 49% of Republican delegates were in support of either civil unions (43%) or marriage (6%) for gay couples. While 90% of Democratic delegates support either marriage (55%) or civil unions (35%), Republican delegates -- the party's conservative base -- are actually more liberal on this issue than Republican voters, only 39% of whom support either option. With 58% of the American public in favor of some form of legal recognition, Republicans are actually closer to the national mood, and are hopefully beginning to understand that Buchananite "cultural war" rhetoric is fast becoming a thing of the past.

To be sure, the GOP still stands on the wrong side of history. Its platform backs the FMA, and goes so far as to declare that, "homosexuality is incompatible with military service" (not merely open homosexuality -- which is barred by the Clinton-era "Don't Ask, Don't Tell" regulation -- but homosexuality itself). At a time when our country faces such perilous threats from abroad, attacking gay people who wish to serve their country in the armed forces is not just cruel. It weakens our national security. And while the Democrats running Congress have yet to move forward on the promises they've made to gay voters, the party is far more welcoming to gays than the GOP. Mr. Obama did refer to "our gay and lesbian brothers and sisters" in his acceptance speech.

As Mr. McCain made clear last week, the last eight years of Republican rule in Washington have forced many people to question whether his party actually stands for its self-declared principles of individual liberty and smaller government. In this regard, he criticized his party for succumbing to the "temptations of corruption" and wasteful spending. But he also could have gone after their cynical stigmatization of an entire class of citizens. That Mr. McCain declined to go after his party on this matter is unfortunate, if understandable, given the grief he's caused them on so many other fronts. It may sound like cold comfort, but gay people have something to appreciate in the fact that, this year, Republicans left them alone.

Mr. Kirchick is an assistant editor of The New Republic.

Fannie Mae's Patron Saint

Taxpayers are now on the hook for as much as $200 billion to rescue Fannie Mae and Freddie Mac, and if you want to know why, look no further than the rapid response to this bailout from House baron Barney Frank. Asked about Treasury's modest bailout condition that the companies reduce the size of their high-risk mortgage-backed securities (MBS) portfolios starting in 2010, Mr. Frank was quoted on Monday as saying, "Good luck on that," and that it would never happen.

There you have the Fannie Mae problem in profile. Mr. Frank wants you to pick up the tab for its failures, while he still vows to block a reform that might prevent the same disaster from happening again.

At least the Massachusetts Democrat is consistent. His record is close to perfect as a stalwart opponent of reforming the two companies, going back more than a decade. The first concerted push to rein in Fan and Fred in Congress came as far back as 1992, and Mr. Frank was right there, standing athwart. But things really picked up this decade, and Barney was there at every turn. Let's roll the audiotape:

In 2000, then-Rep. Richard Baker proposed a bill to reform Fannie and Freddie's oversight. Mr. Frank dismissed the idea, saying concerns about the two were "overblown" and that there was "no federal liability there whatsoever."

Two years later, Mr. Frank was at it again. "I do not regard Fannie Mae and Freddie Mac as problems," he said in response to another reform push. And then: "I regard them as great assets." Great or not, we'll give Mr. Frank this: Their assets are now Uncle Sam's assets, even if those come along with $5.4 trillion in debt and other liabilities.

Again in June 2003, the favorite of the Beltway press corps assured the public that "there is no federal guarantee" of Fan and Fred obligations.

FANNIE MAYHEM: A HISTORY

Click here for a compendium of The Wall Street Journal's recent editorial coverage of Fannie and Freddie.

A month later, Freddie Mac's multibillion-dollar accounting scandal broke into the open. But Mr. Frank was sanguine. "I do not think we are facing any kind of a crisis," he said at the time.

Three months later he repeated the claim that Fannie and Freddie posed no "threat to the Treasury." Even suggesting that heresy, he added, could become "a self-fulfilling prophecy."

In April 2004, Fannie announced a multibillion-dollar financial "misstatement" of its own. Mr. Frank was back for the defense. Fannie and Freddie posed no risk to taxpayers, he said, adding that "I think Wall Street will get over it" if the two collapsed. Yes, they're certainly "over it" on the Street now that Uncle Sam is guaranteeing their Fannie paper, and even Fannie's subordinated debt.

By early 2007, Mr. Frank was in charge of the House Financial Services Committee, arguing that he had long favored some kind of reform. "What blocked it [reform] last year," Mr. Frank said then, "was the insistence of some economic conservative fundamentalists in the Bush Administration who, to be honest, don't think there should be a Fannie Mae or a Freddie Mac." What really blocked it was Mr. Frank's insistence that any reform be watered down and not include any reduction in their MBS holdings.

In January of last year, Mr. Frank also noted one reason he liked Fannie and Freddie so much: They were subject to his political direction. Contrasting Fan and Fred with private-sector mortgage financers, he noted, "I can ask Fannie Mae and Freddie Mac to show forbearance" in a housing crisis. That is to say, because Fannie and Freddie are political creatures, Mr. Frank believed they would do his bidding.

And this is exactly what Mr. Frank attempted to prove when the housing market started to go south. He encouraged the companies to guarantee more "affordable" mortgages, thus abetting their disastrous plunge into subprime and Alt-A loans. He also pushed for, and got, an increase in the conforming-loan limits to allow Fan and Fred to securitize and guarantee larger mortgages. And he pressured regulators to ease up on their capital requirements -- which now means taxpayers will have to make up that capital shortfall.

But the biggest payoff for Mr. Frank is the "affordable housing" trust fund he managed to push through as one political price for the recent Fannie reform bill. This fund siphons off a portion of Fannie and Freddie profits -- as much as $500 million a year each -- to a fund that politicians can then disburse to their favorite special interests.

This is also why Mr. Frank won't tolerate cutting the companies' MBS portfolios. He knows those portfolios (bought with debt borrowed at taxpayer-subsidized rates) were a main source of Fannie's profits before the housing crash, and he figures that once this crisis passes they can do it again. And this time, his fund will get part of the loot.

* * *

Mr. Frank has had many accomplices from both parties in his protection of Fan and Fred. But he was and is among the most vociferous and powerful. In any other area of American life, this track record would get a man run out of town. In Washington, he's hailed as a sage whose history of willful error will be forgotten faster than taxpayers can write a check for $200 billion.

Monday, September 8, 2008

Paulson Says Fannie, Freddie Crisis `All Consuming' (Update1)

Sept. 8 (Bloomberg) -- Treasury Secretary Henry Paulson said the discussions over how to prop up Fannie Mae and Freddie Mac were ``all consuming'' in recent weeks, when he was forced to make a decision he would rather have avoided.

``This is the first time in my career I had trouble sleeping, and it wasn't because it was a difficult decision,'' Paulson said in interview with Bloomberg television. Paulson, 62, took the Treasury's helm in 2006 after a 32-year career at Goldman Sachs Group Inc.

As financial markets deteriorated, resembling the situation in March when Bear Stearns Cos. collapsed, foreign central banks began expressing concerns about Fannie and Freddie, the mortgage companies whose debt they hold. Paulson said that while he preferred not to oversee a government takeover, in the end there was no choice.

``Government intervention is not something that I came here wanting to espouse, but it sure is better than the alternative,'' the Treasury chief said. He spoke a day after the Treasury and Federal Housing Finance Agency put the companies into conservatorship, providing for up to $100 billion of equity investments by the Treasury in each to keep them solvent.

Foreign central banks had concerns about the two companies, in part because of their size, Paulson said. Fannie and Freddie make up almost half of the $12 trillion U.S. mortgage market. U.S. investors also wanted to know what they were facing, he said.

Stocks, Bonds

Fannie fell 79 percent to $1.46 and Freddie lost 71 percent to $1.50 as of 9:53 a.m. in New York Stock Exchange trading. Credit Suisse analysts cut their price target on the companies to $1. At the same time, the companies' bonds rallied.

The rescue won backing from the world's major central banks, including those in Asia where much of the mortgage companies' debt is held.

``This is positive,'' People's Bank of China Governor Zhou Xiaochuan told reporters today in Basel, Switzerland, at a meeting at the Bank for International Settlements. Bank of Japan Governor Masaaki Shirakawa said he expects the takeover to ``stabilize'' U.S. and global financial markets.

Paulson said the current management and boards of the two companies aren't to blame for the firms' situation. They had a ``flawed'' business model with a federal charter and shareholder ownership, and suffered from the rout in the U.S. mortgage market, he said.

No `Happy Time'

The episode has ``not been a happy time for anyone,'' Paulson said. ``I've never been through any situation which was as difficult, as stressful, as complex.''

The Treasury chief reiterated that yesterday's intervention is a ``time-out'' that leaves it to the next Congress and administration to decide on Fannie's and Freddie's long-term structure.

Yesterday's action leaves open the option favored by former Federal Reserve Chairman Alan Greenspan, to split up and sell off the companies, or a full nationalization that would cement the government's role in mortgage markets. Avoiding a decision on the issue enhances the likelihood of congressional backing for the emergency steps, Democratic Senator Charles Schumer of New York said.

Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, warned against any attempt to dismantle Fannie and Freddie.

`Real Problem'

``This will be a real problem'' if the takeover was ideologically driven Dodd said. The Fannie-Freddie model has allowed the U.S. to be the ``only country'' where homeowners are able to get 30-year fixed-rate mortgages, he said.

The FHFA, which will run the conservatorship, ejected Fannie CEO Daniel Mudd, 50, and Freddie CEO Richard Syron, 64. They were replaced by Herbert Allison, 65, former CEO of TIAA- Cref, and David Moffett, 56, who was a US Bancorp vice chairman.

The Treasury also said yesterday it will provide secured short-term funding to Fannie, Freddie and 12 federal home-loan banks, and purchase mortgage-backed debt in the open market. The New York Federal Reserve Bank will act as the Treasury's agent for the lending facility.

``This is not a permanent solution -- they've not saved Fannie and Freddie, what they've done is they've bought 15 months,'' said Bill Ackman, founder of Pershing Square Capital Management in New York, which has sold short the two companies, or bet on declines in their securities. ``It's a band-aid. They haven't permanently recapitalized the companies.''

Bond Rally

Yields on Fannie Mae and Freddie Mac debt relative to Treasuries tumbled by the most on record on rising confidence in their creditworthiness after the government takeover.

The difference between yields on Fannie's five-year debt and five-year Treasuries fell 29.1 basis points to 64.9 basis points as of 8 a.m. in New York, the lowest since May, according to data complied by Bloomberg. The yield fell to 22.1 basis points below interest-rate swaps, another benchmark, the lowest since February and down from 4.8 basis points.

The takeovers bring Fannie, formed after the Great Depression and spun off in 1968, and Freddie, created in 1970, back under the government's fold. It's the biggest step yet in officials' efforts to grapple with a yearlong credit crisis that has caused more than $500 billion of losses and writedowns.

Under the plan, the Treasury will receive $1 billion of senior preferred stock in coming days, with warrants representing ownership stakes of 79.9 percent of Fannie and Freddie. The government will receive annual interest of 10 percent on its stake.

Portfolio Limits

As a condition for the assistance, Fannie and Freddie eventually will have to reduce their holdings of mortgages and securities backed by home loans.

While common stockholders of Fannie and Freddie won't be eliminated, they will be last in line for any claims, Paulson said. Preferred shareholders will be second in absorbing losses, he said. Interest and principal payments will continue to be made on the companies' subordinated debt, Lockhart said.

The government is taking an increasing role in financial markets, after the Fed six months ago provided $29 billion of financing to prevent the collapse of Bear Stearns Cos. Chairman Ben S. Bernanke praised yesterday's action.

Democratic presidential nominee Barack Obama said yesterday that ``some'' intervention was necessary to prevent a ``larger and deeper crisis.'' After the current crisis subsides, ``the plan must move toward clarifying the true public and private status of our housing policies,'' he said.

`Downward Spiral'

``We've got to keep people in their homes,'' Republican presidential candidate John McCain said in an interview with CBS's ``Face the Nation'' program. ``There's got to be restructuring, there's got to be reorganization, and there's got to be some confidence that we've stopped this downward spiral.''

The government takeover comes almost two months after Paulson first sought emergency powers to inject capital into the beleaguered mortgage-finance companies. Congress approved the measure in legislation signed by President George W. Bush on July 30.

Paulson had indicated until early last month that it was unlikely he'd use the authority, and then kept silent even as investors clamored for clarity on how a government intervention would work.

``There are an enormous number of decisions ahead and they will be very controversial and there will be a lot of conflict,'' William Poole, former president of the Federal Reserve Bank of St. Louis, said in a Bloomberg Television interview. ``We don't know what the ultimate cost is. If they lose 5 percent on all their obligations, that doesn't seem like an outrageous amount to lose. That's right away $300 billion.''

MBS Purchases

Included in yesterday's measures is a Treasury program to purchase new mortgage-backed securities from the two companies, starting with a $5 billion purchase this month.

The Treasury will also hire independent asset managers to purchase and run the portfolio of mortgage-backed securities it will buy. ``There is no reason to expect taxpayer losses from this program, and it could produce gains,'' the department said.

Paulson's decision, taken after consulting with Bernanke, followed a review that found Washington-based Fannie and McLean, Virginia-based Freddie used accounting methods that inflated their capital, according to people with knowledge of the decision.

Morgan Stanley Role

Paulson hired Morgan Stanley a month ago to probe the companies' finances. The investment bank concluded that the accounting, while legal, enabled Freddie, and to a lesser extent Fannie, to overstate the value of their reserves, according to the people who declined to be identified because the findings were confidential.

Fannie and Freddie own or guarantee almost half of the $12 trillion in U.S. home loans and the government had been leaning on the companies to help pull the economy out of the housing crisis.

Concern over the companies' capital pushed their borrowing costs to record levels over U.S. Treasuries, sent their common and preferred stocks tumbling and boosted mortgage rates. Fannie is down about 93 percent in New York Stock Exchange trading since the end of June. Freddie has fallen about 92 percent.