Investment Markets » Banking and Finance
Fannie and Freddie
The near collapse of America's $5.3trn mortgage giants is evidence that the crunch has hit a new and more deadly phase.
Roller-coaster fans know the feeling: that horrible tingle of fear and uncertainty when the carriage has finished its slow crawl to the top and you are about to plunge into God knows what. That's how it felt when the news broke that Fannie Mae and Freddie Mac – the two government-sponsored guarantors of the US housing market – were trading at half their book value and could be about to go bust.
Had that happened, the result might well have been curtains for the global banking system. Between them, the two Fs hold or back around $5.3trn of debt – around 38% of US GDP. They were simply too big to fail and, sure enough, the US authorities – led by Treasury Secretary Hank Paulson – stepped in.
The couple with the folksy names are among the oldest institutions in American finance. Fannie was set up by Roosevelt to revive the Depression-era housing market; Freddie arrived in 1968 to provide competition. They are the lynchpin of the US mortgage market, yet their exact status as government-sponsored enterprises has long been confused and was a major factor in the recent crisis.
Fannie and Freddie were an accident waiting to happen. Ostensibly trading as private firms, they enjoyed an implicit government guarantee of their debts, with the upshot that they were able to borrow cheaply and massively expand their books. They morphed over the years into nothing short of a racket.
Because they were only guaranteed prime mortgages, F and F were unaffected by the first subprime fall-out. But as house prices continued to fall, their liabilities mounted. In bailing out, investors were essentially calling the government's bluff.
Paulson's rescue plan does not amount to a bail-out which, in itself, would have been a disaster. Had the US government attempted to shoulder F and F's debts, the gross financial liabilities of the government would have exceeded 100% of GDP, sending the dollar into free-fall.
His promise of extra funding and the Treasury's new powers to buy shares if necessary were intended to boost confidence – and they succeeded in part. But the fundamental problem remains unresolved: ultimately, the US taxpayer is on the hook. Paulson must assert control over these poorly regulated and abysmally managed semi-socialist giants until the crisis abates. After that, he should consider how they might be wound down of sold in parts to the private sector.
This episode has shaken both America and the rest of the world. We thought we were over the worst, but we are still in the jaws of the crisis.
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