Monday, 8 September 2008

The reasons behind the Fannie and Freddie bail-out

As the old saying goes, they do everything bigger in America.

Here in the UK, the government nationalised Northern Rock, a regional banking minnow whose failure wouldn't really have been very important on the scale of global finance, despite the hefty political fall-out.

Over in the US, they'll happily let their regional banks fail. Northern Rock wouldn't have stood a chance. But while the free market ethos might be applied in some instances, the US is more than happy to invoke the "too big to fail" clause when it wants to. Yesterday, the US government took over what are probably the most important financial institutions in the world at the moment, mortgage groups Fannie Mae and Freddie Mac.

The move will drag these two monsters kicking and screaming onto the government's balance sheet. According to The Telegraph, it represents a potential liability of £2,900bn. That's about £10,000 a piece for every man, woman and child in America.

Better start saving now, guys...


The reasons behind the Fannie and Freddie bail-out

Fannie Mae and Freddie Mac don't write mortgages themselves, but they own or guarantee almost half of America's $12 trillion mortgage debt. With the housing market in freefall, that's inevitably lead to a crisis of confidence in the companies' balance sheets. Their shares have been hammered - and after this latest move, shareholders seem likely to be wiped out altogether.

But it's not the shareholders who were the problem - it was bond holders. Fannie and Freddie are still responsible for almost 70% of new mortgage loans in the States. They raised cheap money by issuing bonds, and were thus able to fund cheap mortgages for US home buyers.

Now Fannie and Freddie have always inhabited a kind of "nudge, nudge, wink, wink" financial hinterland. The US government didn't exactly say it was responsible for the two mortgage providers. But everyone knew it was. So that meant that the two companies were able to borrow money at the same rate as the US government.

That's ended recently as fears for Fannie and Freddie's future grew. All those foreign governments buying up Fannie and Freddie debt suddenly started to worry - wait a minute, maybe these guys aren't bluffing. Maybe they really won't pay back any of the loans that we've got here. And that sent them rushing for the hills. That increased the cost of borrowing for Fannie and Freddie, which in turn made US mortgages more expensive.

How much is this going to cost?

So now the US government has been forced to turn around and explicitly back Fannie and Freddie. How much is this going to cost? Well, just like Northern Rock, the answer is that nobody really knows. The US Government is crossing its fingers and hoping that things go well enough so that it might even turn a profit at a later date as it gradually runs the two behemoths down. But as Hank Paulson admits, "the ultimate cost to the taxpayer will depend on the business results... going forward."

The general consensus is that this will make things better. Ruth Lea of Arbuthnot Banking Group tells The Telegraph: "this is good news for the global economy. The Fed has clearly taken a view that to allow these two to go under would have been horrendous."

But as Paul Kedrosky points out on his Infectious Greed blog, the fact that this has happened at all shows how bad things are. The Bush administration would far rather have put this off until after the election, making it the next president's problem. The fact that they couldn't "tells you how fast and out-of-control this apple cart is."

This is turning into a dirty great game of "pass the parcel" where nobody wants to be left holding the package. The bail-outs just keep getting bigger and bigger. And every time it happens, the idea of moral hazard is dismissed as being noble, but inapplicable in this case, because the consequences of collapse are just too great.

Let's track this back. We've gone from a situation where we bailed out a single hedge fund - Long Term Capital Management (LTCM) - in 1998. That fund, which had fewer than 200 employees, was deemed too big to fail at the time. Then the tech bubble burst, and Alan Greenspan slashed interest rates to bail out Wall Street. And now the housing bubble has burst, and slashing interest rates isn't enough. So the mortgage industry is being bailed out directly.

Meanwhile, every other industry is putting the begging bowl round for subsidies. The car makers want money from the government too. How long before the retailers start asking for a hand-out (though you could argue that they've already had theirs, in the form of the tax rebate earlier this year)?

Rising interest rates, a weaker dollar - stick with gold

America's stock of bad debt has now gone as far up the tree as it can. It's all with the government and the taxpayer now. I don't know what that means for the dollar today, but it can't be good in the long run. The government's aim has to be to inflate that debt away, and forget about the consequences.

As Roben Farzad points out in BusinessWeek this week, US savers must feel absolutely sick. Their reward for resisting "the siren call" of debt is "injurious savings yields, inflationary rot, and election-season neglect, all served up with a dollop of institutional insecurity." David Gitlitz of investment adviser TrendMacrolytics tells Farzad that with the Federal Reserve rate cuts, "rates haven't been this negative" since the 1970s.

The trouble is, the world has changed, but nobody seems to get it yet. Our past decade of care-free debt accumulation has been built on the US consumer spending money borrowed from Asia, on goods made in Asia. But now the US consumer is spent out, so that cycle can't carry on.

Asian governments might still be keen to prop up the dollar, but once they realise that their exporters aren't selling anything, regardless of how weak their currencies are, they'll stop. Why lend money to these people if they're not keeping their side of the bargain and spending it in your factories? And so, to keep borrowing money and rolling over its massive debts, the US will have to pay more interest, which means higher interest rates in the long run.

We'll see what happens. But in the meantime, this bail-out gives you another good reason to be holding onto gold. Think of it as insurance: if we face inflation, it'll preserve its value. If we end up facing deflation and financial instability, it'll lose out less than other assets. I'd stick with it.

Turning to the wider markets...



UK shares sold off sharply, with the FTSE 100 index eventually closing 2.3% down, 121 points, at 5,241. Over the week, the index dropped 7% to just 90 points above the 2 ½-year low hit in July, while the FTSE 350 mining index plunged 18% in its biggest monthly fall since 1987. Also over the week, the FTSE oil and gas index slid almost 10%. Amongst the worst hit stocks was car catalyst maker Johnson Matthey, which slipped 8.5%. Resource stocks suffered generally, with Kazakhyms and ENRC both tumbling 8% and Lonmin down 4%. In financials, Friends Provident slipped 4.4%. But Cadbury gained 2% on disposal talk.

In Europe, shares also dropped back sharply, with the German Xetra Dax easing 2.4% to 6,127 and the French CAC 40 sliding 2.5% to 4,197.

US markets were mixed, with the Dow Jones Industrial Average nudging up 33 points to 11,221 and the wider S&P 500 gaining 0.4% to 1,242, though the tech-heavy Nasdaq Composite eased 0.1% 2,256. News that unemployment had risen to 6.1%, a 5-year high, was offset by a rally in financials.

Overnight the Japanese market rallied 412 points, 3.4%, to 12,624, and in Hong Kong the Hang Seng gained 739 points, 3.7%, to 20,673.

This morning Brent spot was trading at $104, spot gold was at $815, silver at $12.57 and platinum at $1,374.

In the forex markets this morning, sterling was trading against the dollar at 1.7786 and against the euro at 1.2408. The dollar was trading at 0.6977 against the euro and 108.92 against the Japanese yen.

And in London this morning, Associated British Foods, food producer and owner of Primark, said profits will rise in the second half. The group has managed to pass through higher commodity prices to customers, while profit is also up at Primark as consumers trade down to discount shops. 
 

 

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