Mac Mae be the biggest bailout

The most astonishing aspect of the US government rescue of Freddie Mac and Fannie Mae, the home loan giants, was not the immediate cost, although at an estimated $300bn (£170bn), it is eye-watering.

What really took the breath away was that a free-market Republican administration had effectively nationalised almost half of the $12 trillion America mortgage market.

As Hank Paulson, phlegmatic US Treasury secretary, said: “Government intervention is not something I came here wanting to espouse, but it is sure better than the alternative.”

The move is the most significant in the credit crunch so far, more so than the Fed’s rescue of Bear Stearns in the US, or Northern Rock in Britain, both in terms of the sums involved and the scale of state intervention.

But does it mark a turning point in the authorities’ battle to stem the decline in asset prices, whether stocks or houses, since the crisis kicked in on 9 August 2007?

Stop the rot
Probably not. Analysts warn the intervention was necessary to prevent the outbreak of an even worse crisis, rather than engineer a turn in market sentiment.

“Rather than marking the turning point that assures an economic recovery, the support that has had to be provided simply underlines the severity of the ongoing credit crisis,” says Julian Jessop, international economist at Capital Economics.

An official bailout had been on the cards since Paulson won approval from the US Congress in July to pump unlimited amounts of capital into stricken financial companies in an emergency.

The trigger for the intervention was not a desire to underpin US house prices, but fear that failure of either Fannie or Freddie would spark outrage among the foreign central banks and sovereign wealth funds that had invested more than $300bn in bonds issued by the two government-sponsored enterprises (GSEs).

At the end of August, Yu Yongding, a former adviser to China’s central bank, told Bloomberg that if the US government allowed Fannie and Freddie to fail and international investors were not compensated adequately, “the consequences will be catastrophic”.

“If it is not the end of the world, it is the end of the current international financial system,” he added.

Foreign central banks hold large volumes of bonds issued by both agencies. Allowing them to collapse would have them nursing heavy losses and an unwillingness to carry on financing the US deficit.

Graham Turner, a City economist at GFC Economics, says: “Nobody could ever have doubted that Freddie and Fannie would be [rescued] with the Chinese making such explicit threats.”

Federal Reserve data show foreign central bank holdings of agency debt dropped by $26bn in the seven weeks to 3 September, $9.8bn of which was slashed in the week before the bailout. “The outflow seemed to be accelerating,” says Stephen Lewis, chief economist at Monument Securities in London.

No more bailouts
Hopes that Paulson’s action would stem falling confidence abroad was knocked by the Korean Development Bank’s decision to call off talks over buying a stake in Lehman Brothers, tipping the 158-year-old Wall Street bank into crisis. Even more significant was the fact that Paulson made clear there would be no more Freddie-style bailouts, forcing Lehmans into bankruptcy and Merrill Lynch into the arms of Bank of America.

From these events now emerges another potential crisis. US investors have bought an estimated $1.4 trillion of credit default swaps (CDS) ­ insurance policies against default.

Putting Freddie and Fannie under government control amounts to default, meaning those contracts may have to be settled, although since dealers never disclose CDS positions, it may take some time to emerge.

Paulson was hoping his actions would underpin the housing market and bring down mortgage rates.

Capital Economics estimates the move will cut the yield on mortgage interest rates by one percentage point taking a 30-year rate from 6.4% to a four-year low of 5.4%.

However, that may not be enough to put a floor under the US housing market, given the excess of supply, the rate of repossessions and the rise in unemployment.

It seems the rescue of Fannie and Freddie was a necessary, but not sufficient condition for recovery.

As Capital Economics’ Paul Ashworth says: “If the Treasury had allowed them to fail, the only significant source of funding in the mortgage market would have disappeared.”

This begs the question as to whether the UK should follow suit. So far, news of the US slashing rates and bailing out failing institutions has met with stony faces in European capitals.

One reason is that the US is guided by a fear of a return to the Great Depression, while Europeans fear hyperinflation.

Different strokes
There are more practical reasons why the UK may not follow the US’s example despite growing political pressure. The Treasury is probably right in saying that we have a different mortgage market from the US.

The UK does not have equivalent organisations to Freddie and Fannie. The collapse of Northern Rock shows that certain mortgage lenders may have an implicit guarantee.

While mortgage finance has dried up in the UK, the problem is a spike in mortgage rates combined with still-high house prices.

As the interim report into mortgage finance by FSA deputy chairman Sir James Crosby showed in July the e280bn of outstanding residential mortgage-backed securities in the UK compares with e4.69 trillion in the US, of which 82% was backed by agencies such as Freddie and Fannie.

Mervyn King, Governor of the Bank of England, has firmly set his face against any further taxpayer guarantee for mortgage funding.

He told MPs in September that a new permanent facility to replace the Special Liquidity Scheme ­ which allowed banks to swap illiquid mortgage-based assets for Treasury Bills as collateral to raise cash ­ would not be as large. He said the new scheme, which supersedes the old one in late October, “would not and cannot solve the shortage of funding to finance bank lending, including mortgage lending”.

UK house prices, as in the US, will continue to fall, mainly because only that way will they find a natural floor. As King said at his August inflation briefing, neither the government nor the bank can set that new level.