John, Jane Doe pick up tab for Fannie and Freddie
THE X FACTOR: Don Stammer
July 30, 2008
THE US monetary authorities recently announced support packages for two giant mortgage lenders experiencing financial stress -- Fannie Mae and Freddie Mac.
The announcement is unambiguously good for Australian investors but a longer-term worry for Americans, especially US taxpayers.
Fannie Mae and Freddie Mac are government-sponsored enterprises that between them finance or guarantee over $US5 trillion ($5.1 trillion) of housing mortgages in the US. Fannie Mae was created as a government agency in the 1930s Depression and privatised in 1968, though retaining a cosy relationship with the US Government. Freddie Mac was set up in 1970, also as a government-sponsored enterprise, to provide competition.
Fannie Mae takes its name from the initials of the Federal National Mortgage Association. Freddie Mac is the (somewhat contrived) acronym for the Federal Home Loan Mortgage Corp.
Fannie and Freddie do not lend directly for housing, but they finance the mortgage loans of home lenders using funds borrowed on professional markets by issuing debt or on-selling packages of mortgages. They also guarantee the payment of interest and repayment of principal on housing loans.
Over the years, Fannie and Freddie have borrowed huge amounts of money from US investors but also from lenders in other countries, including many central banks.
Despite the capital bases of the two companies being rather skinny -- at the end of last year, borrowings were an awesome 65 times their capital bases -- Fannie Mae and Freddie Mac have been able to borrow at interest rates not much higher than those on US government bonds.
That's because their debt has been seen as carrying the implicit backing of the US Government -- the Government has not confirmed such commitment and, indeed, prospectuses have warned that their borrowings are not government guaranteed.
The global credit crisis, which has been running now for almost a year, has taken its toll on Fannie Mae and Freddie Mac.
The demands on them to refinance existing mortgages of banks and other lenders have increased.
They have had to write down the value of assets. And their share prices have plunged by about 80 per cent over the 12 months to mid-July, creating the risk they will be unable to absorb further losses and asset write-downs -- with devastating effects on the already strained housing market.
To head off these problems, the Bush administration has proposed government lending to, and investment in, Fannie Mae and Freddie Mac, and the Fed has announced that they will have access to central bank lending on terms similar to those available to banks. (And, as the Fed accepts the debt of government-sponsored enterprises as collateral when it lends, the two mortgage lenders might even come to the discount window offering each other's paper as security for their loans.)
In normal circumstances, the US Treasury and the Fed would not have contemplated providing this generous support to mortgage lenders.
But these are not normal times. The scale of mortgage debt held or guaranteed by Fannie Mae and Freddie Mac, the long-held view that these institutions carried an implicit guarantee from the Government, and the continuing pain in US housing (illustrated in my chart) make them "too big to fail".
The announcement by the US monetary authorities seems to have achieved its short-term aims.
Even though a rating agency (belatedly) has downgraded their credit rankings, Fannie and Freddie appear comfortable in refinancing their maturing debts and maintaining the guarantees they've provided, and their share prices have stabilised. For investors around the world, including Australians, these interventions by the US monetary authorities are good news.
The broader strains in global credit markets, which had intensified over early July, have eased.
Moreover, the US monetary authorities are showing they are prepared to do whatever it takes to help ease the credit crunch.
Of course, the many investors holding Fannie Mae or Freddie Mac debt -- directly or via managed funds -- can breathe more easily.
Americans will reap these benefits and also take comfort from the better prospect that house prices can soon stabilise. But the moves to support Fannie and Freddie will raise longer-term problems for the US.
Expectations have been created (or, at least, intensified) that the US monetary authorities will stand behind any other big financial institutions imperilled by the credit squeeze -- and that, in any future credit crunches, Fannie Mae and Freddie Mac will again be bailed out by government.
It will be a difficult, over coming years, for the US monetary authorities to achieve the disciplined financial behaviour by banks and other financiers that is a key ingredient of stable and well-functioning credit markets.
The interventions will also be expensive for US taxpayers, who ultimately pick up the tab for the support provided to Fannie Mae and Freddie Mac.
It is possible, too, that the scale of the support could even stretch the Fed's balance sheet.
Renationalising Fannie Mae and Freddie Mac is not an option, as the whole of their debt would then -- formally -- be brought on to the balance sheet of the US Government and about double the level of the (stated) public debt.
Dr Stammer chairs Praemium Ltd and the investment committee of the Portfolio Solutions Group at ING Investment Management. The views expressed are his alone
http://www.theaustralian.news.com.au...013988,00.html