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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.

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