Vericool Finance

They don’t come much tougher than Hank Paulson, but even the doughty US Treasury chief admits to suffering sleepless nights while wondering what to do about Fannie Mae and Freddie Mac. As well he might. Fannie and Freddie own or guarantee around half the $12trn US mortgage market, and they were headed towards insolvency. Had that been allowed to happen it could have brought on the collapse of the US mortgage market, if not the entire financial system.

Paulson had to step in and take them under federal control – even though the move will add countless billions to the national debt. They were simply too big to fail.

Fannie and Freddie were originally devised to ease the US housing market, so who exactly are they and what folly or misfortune has brought them from prim respectability to this apparently shameful turn of events?

Fannie Mae (the Federal National Mortgage Association) was born out of the Depression, as part of a series of measures introduced by F.D. Roosevelt to kick-start the housing market. The idea was to introduce a secondary market in mortgages. Fannie would purchase them from their original lenders and package them together in bonds for sale to investors – thus providing more lenders with more liquidity to make more mortgages.

Freddie Mac (the Federal Home Loan Mortgage Company) was introduced has a competitor in 1970. Both were ostensibly private organisations, with ordinary shareholders, but having been chartered by Congress, they had the status of government-sponsored enterprises. And therein lay their downfall.

Bolstered by an implicit government guarantee, Fannie and Freddie became increasingly aggressive and took unnecessary risks – ending up with more than $5trn in mortgages on their books, backed by an absurdly slender capital cushion.

The Fannie-Freddie bailout is one of the great political scandals of our age. Paulson’s action may get the companies through the current crisis – albeit at enormous cost to US taxpayers – but it doesn’t go far enough. Until he takes action to kill of the Fannie and Freddie business model, these corpses could still return to haunt us. Once house prices have stabilised, the Treasury should break up and privatise these hybrid monsters as swiftly as possible.

Financial rescues do not come any bigger than this, but there may be some catharsis in the Fannie and Freddie bailout as a turning point for the global banking system. It signals that the most acute phase of the financial crisis is past, but the long convalescence has not yet begun.

Given that scarcely a day has gone by this summer without some bad news about the housing market, it was sensible for the Prime Minister to begin his autumn fight-back by offering some consolation in this area. But the long-awaited package fell short of expectations, as well as posing questions about the Government’s capacity for joined-up thinking.

The £1bn proposal, introduced by Housing Minister Hazel Blears, is mainly intended to help first-time buyers and homeowners in financial difficulty. The main measures include: a year-long “stamp duty holiday” on residential property sold for less than £175,000; a shared equity plan offering low- to middle-income families free loans of up to a third of a property’s value; a mortgage rescue scheme for those vulnerable to repossession; and extra cash to allow social landlords and councils to build more affordable homes.

Some of the proposals are welcome, but taken as a whole, the package is a cloud of confusion. Smoothing the rough edges of a housing slump is one thing; trying to offset the decline is quite another. The temporary cut in stamp duty, for instance, will have no more effect on boosting the market than King Canute’s command to the tides.

Why would buyers rush into a falling market to save £1,750 when, on current trends, they could hope to save ten times as much if they waited a year?

Why indeed. The unaffordability problem is rapidly being solved without government intervention; the only sensible policy is to let the market find its own level. There are few problems so bad that a government cannot make them ten times worse by intervening, and this attempted bailout is no exception. By protecting borrowers and lenders from the consequences of their actions, the Government will simply be encouraging even more reckless behaviour in the next housing boom.

Government interventions have a history of creating damaging distortions in markets, but these proposals are so irrelevant that they can’t possibly have any impact. Britain’s housing market has ground to a standstill because mortgage financing has dried up.

If the £200bn that the Bank of England has made available to lenders has had no appreciable impact, it’s hard to see how the Government’s piffling £1bn will alleviate the problems.

This package doesn’t stand a chance of putting a floor under the property market. But that’s not how it will be judged in Whitehall anyway. Its primary purpose is to provide Gordon Brown with breathing space while he fights for his political life. It may not succeed even in that.

A year into the downturn, the crunch has claimed its most prominent victim yet – a 736ft, Richard Rogers-designed tower on Leadenhall Street known as The Cheesegrater, which would have become (briefly) the City’s tallest building.

The developer, British Land, has learnt that what is “location, location, location” in the residential market, translates to “timing, timing timing” for commercial property. It has delayed the project until building costs fall and the decimated office market recovers.

The Cheesegrater is one of a crop of City buildings scheduled for completion before 2012, but in the current climate, it will take a brave developer with very deep pockets to press ahead. Rival Land Securities has also delayed its Walkie-Talkie building, and it comes as little surprise that the three towers still sticking to their original deadlines – the Shard, the Pinnacle and Heron Tower – all have Middle Eastern petrodollars behind them.

British Land should count itself lucky that it could pull the plug before serious construction got under way. Clearing a site for a Cheesegrater is expensive, but not compared to being saddled with an empty hulk – the kiss of death for a building’s reputation that makes profitable letting even harder.

There’s another reason why British Land’s investors should be relieved. In an effort to raise £1bn a year, the Government has imposed an “empty rates” tax on vacant buildings, doubling the payments demanded from landlords and sometimes adding hundreds of thousands to the running cost of a single building.

Scores of property developers now have plans to demolish offices, warehouses and shops, leaving Britain’s cities looking like a postwar wasteland.

Skyscrapers are architecture’s sunflowers. Given a good, sunny financial climate, they soar into the urban firmament. But their fate is at the mercy of economic swings, and contemporary city skylines can be read as graphs of the ups and downs of the economy.

Many Londoners, including Mayor Boris Johnson, will breathe a sigh of relief at this latest setback. They question the wisdom of building a prominent cluster of skyscrapers so close to St Paul’s and the Tower of London. But this pause is more likely to be a semi-colon than a full-stop.

The Square Mile is determined not to lose its lead to upstart rival areas; and, as Canary Wharf grows taller and bulkier, the City feels obliged to follow suit. The recession might be a good time to pause and think about the skyline, but all the indications are that when the sun shines again, the way forward will be, literally and lucratively, upwards.

Here’s an unmissable business proposition: How would you like the Government to guarantee your every liability? It would certainly come in handy should a big client go bust, or if you had bad credit card debts; or, indeed, to help manage any of those other little uncertainties to which a business is prone.

Sounds farfetched? It’s exactly the deal that mortgage lenders are attempting to push on the Government to tackle the defunct market in mortgage finance, which has all but dried up since the onslaught of the credit crunch: demand for home loans fell 68% year-on-year in June.

And it’s not just the lenders who want action. Estate agents, house builders, cabinet ministers, and every other beleaguered group with an interest in reviving the housing market are on the same bandwagon.

Hence the anticipation greeting former HBOS chief Sir James Crosby’s interim report on the mortgage crisis. But help there came none. Sir James’s central conclusion – that the situation is bad and unlikely to get better for at least three years – is depressing enough. What’s more he believes there’s virtually nothing that can be done about it.

There were hopes that Crosby might endorse an extension of the Special Liquidity Scheme (the emergency measure under which the Bank of England advances loans to banks); or even call for the establishment of a government agency, along the lines of America’s Fannie Mae and Freddy Mac, to guarantee UK mortgages.

No such luck. Had Chancellor Alistair Darling asked the famously hair-shirted Bank governor Mervyn King to conduct the review, he could scarcely have got a more unpalatable result. King’s view is that, for reasons of moral hazard, the markets must be allowed to take their punishment, however uncomfortable to ordinary householders. Sir James seems to be of much the same opinion.

Creating Gordon Mac might breathe life into mortgage-backed securities but it would postpone a solution to the core problem. The main issue is not the supply of credit, but the wilting demand for it from consumers convinced that Britain’s spivved up housing market has further to fall. Nothing will be resolved until overvalued property prices fall steadily back to Earth.

But there was no need for Crosby to succumb to such blatant defeatism. There are plenty of ways to ameliorate the misery without putting the taxpayer on the hook or bailing out the banks – and it is in the Government’s own interest to act now.

Darling has made it clear that he will wait until the autumn’s pre-Budget report to act. By then, on current trends, the Government may have a real crisis on its hands.

The money crisis that has been afflicting banks for months now has turned into a mortgage squeeze. As lenders scrambled to withdraw products and tighten terms (effectively pricing out first-time buyers altogether), the market has ground to a virtual standstill.

Survival is currently a higher priority for banks than winning new business. The big worry is that a sharp contradiction in lending will cause not an orderly correction in prices, but a confidence-destroying crash. Bang on cue, the Halifax reported a 2.5% fall in UK house prices in March: some five times larger than expected and the steepest monthly fall since the dark days of 1992.

With the IMF suggesting that UK house prices are over-valued by some 30%, the spectre of negative equity is again stalking the land. The credit reference agency, Experian, suggests that more than 75,000 households could be vulnerable. But will the market really crash?

The current situation is very different from the Nineties when the UK was in recession (it isn’t now – yet) and interest rates were sky-high. However, some things are worse. Overall debt levels per household are much higher, as are house prices relative to incomes – and there’s also the threat of a rout in a much-expanded buy-to-let sector.

Even so, today’s homeowners are a good deal better cushioned with equity than their predecessors. Back in 1990, over a third of first-time buyers had 100% mortgages, creating an immediate pool of buyers at risk from negative equity; the equivalent figure last year was just 5%. Still there’s no doubt we’re in for a correction – and a good thing too.

Recent house-price falls should be set against a 170% rise over the past decade. A return to saner pricing and saner lending was inevitable. It will be painful in the short term, but desirable for all in the long term.

Whether or not house price crash – and most experts predict a 10% fall is the likely scenario – there’s no doubt the UK economy is in for a bout of austerity. The shutdown of the discount mortgage market could be the last straw for many households already hit by higher taxes and fuel and food inflation.

And there’s little the authorities can do to get us out of this hole. Even if the Bank of England makes a hefty interest-rate cut, it’s unlikely that cash-strapped banks will pass it onto consumers. The economy is in too much trouble for rate cuts alone to help.

The four most dangerous words in financial markets are supposed to be “it’s different this time”, but another four – “it won’t happen here” – come a close second. The US may be in the throes of a boom-and-bust housing crisis, but British pundits still insist that a gentle slowdown is on the cards here, despite a trebling of prices in the past decade.

The UK market is a “special case”, they argue, but let’s be clear: if the British property market looks like a bubble, feels like a bubble, then it is a bubble… and it is dangerously close to bursting.

It took the headline writers at the Express to state the danger in its starkest terms: “100 days to halt the housing crash” – the argument being that the Bank of England needs to start cutting interest rates by February to prevent any small early-year blip exploding into something worse.

It did the trick in 2005, but the situation now is very different. We’re in the midst of a prolonged credit squeeze and the key source of mortgage funding – wholesale markets – has dried up. Even radical action from the Bank is unlikely to make a difference.

Under normal conditions, the Bank’s interest rate determines all other short-term rates. But hard cash is such a prized commodity that the one-month money-market rate, at 6.75%, is a full percentage point above the base rate. The Bank must send a signal and cut rates, but it won’t solve the basic problem, which isn’t just the price of credit but it’s sheer availability.

How bad could it get? If you’re one of the 1.5 million people who have to remortgage next year, the answer could be very nasty indeed. The Financial Services Authority warns that many homeowners may find it difficult, if not impossible, to find an affordable deal: some face a 60% hike in monthly payments. Even so, the economy is in radically different shape than during the dark days of the last crash in the early Nineties so the degree of pain should be less.

The market is arguably more over-valued now than it was then and the buy-to-let market is highly vulnerable. No one knows whether we’re in for a 2% slide or a 30% crash, but sharp falls could become widespread if buyers and sellers expect a sustained fall: the self-fulfilling dynamic that can turn a correction into a rout.

Confidence will keep house prices stable. Unfortunately, it’s thin on the ground at the moment.