Initial thoughts on the Fannie Mae and Freddie Mac “Bail Out”!

 

The dramatic decision by the American Government to remove uncertainty as to the solvency of the two giant Government Sponsored Entities (GSE) active in the home mortgage market is very welcome.

 

The initial market reaction was positive, as expected, particularly in the financial sector. Indeed, the announcement confirms the full assumption by the United States government of the responsibility for meeting the debt service (senior and subordinated) in timely fashion, risk to which the financial sector was particularly exposed.

 

In acting decisively, a major financial crisis, which would have spread from the United States to global financial markets, has been avoided.

 

However, after an initial sigh of relief, it is important to analyse the consequences of an operation, the size of which has no historical precedent.

 

At a stroke, the official debt of the United States has more than doubled

 

Though the “solvency” of the US Government is not in question, the impact of the move should have important inflationary consequences. It represents a first and dramatic example of the way inflation will play a significant role in re-establishing the financial system on a sound footing, as alluded to in my recent paper dated September 2.

 

If commentators give near unanimous praise for Secretary Paulson’s handling of the situation, it should however be understood that the major impact on the taxpayer will derive from the unavoidable increase in the overall cost of servicing US Government debt over time rather than from any immediate effect of the guarantee granted over the week-end. The size of the refunding needs should exert an upward pressure on interest rates, all other conditions remaining equal, but the phenomena will be largely obfuscated by the diverging evolution of all factors influencing the level of interest rates.

 

While, foreign holders of US Government and Agency debt (including Central Banks and other Sovereign Wealth Funds) will be reassured, it remains to see whether they will remain as favourably disposed to acquire additional US Government securities and/or whether they will demand higher returns. It is true that part of the answer to this question stems from the devastating effects that the use of a “Weapon of Mass Financial Destruction” would have on global markets if a major shift of investment strategies were to be implemented brutally. Contrary to “WMD”, there is no anti-proliferation treaty covering WMFD, so that in the latter field multilateral cooperation is not an option but has become an obligation.

 

 

The recognition of the ultimate financial responsibility for GSE should entail a tightening in spreads of Agency over US Treasury securities. This should be welcome relief for the ongoing funding of the two rescued entities and restore prospects of their long term profitability. In the interval, this situation accentuates the competition with the private sector operators in the mortgage market (50%), which casts serious doubts as to the likelihood of an improvement in the real estate market.

 

One should also expect a further widening of spreads between Government and private debt. Indeed, while refinancing rates of banks with their respective Central Banks remain favourable,(despite the tightening effective February 1 announced by the ECB), they have not, so far, led to a noticeable improvement in the inter-bank market, where rates remain high. Together with the overall tightening of credit availability, this situation does not bode well for economic recovery.

 

Despite the stabilising of “available” official credit for the housing market until the end of 2009, it is far from clear whether the rescue measures will be sufficient to put a floor under the US real estate market and/or whether it is realistic to believe that the private market will be in a position to relay the announced shrinking of 10% p.a. of official mortgage portfolios starting in 2010. This is all the more problematic that regulators and shareholders are already insisting on tighter credit criteria reducing the access to credit for number of prospective house buyers, regardless of the attractiveness of house prices. Any further signs of recession and mainly a continuation of the trend of rising unemployment should make the stabilisation of the housing market, let alone its recovery, more problematic.

Conclusion:

 

Other than the welcome clarification of the status of the debt of Fannie Mae and Freddie Mac and the avoidance of a systemic financial crisis that their failure would have created,  the announcement over the week-end does not in any significant way improve the existing underlying fragile economic and financial environment.

 

The contradictions imbedded in economic and monetary policies carried out on both sides of the Atlantic, remain unchanged. This situation, coupled with the numerous stress points on the geopolitical scene (Iraq, Afghanistan, Pakistan, Georgia, Middle East etc.), should ensure that market volatility remains high. Standard correlations between interest rates, foreign exchange rates, commodity prices and economic activity may not hold, making specific predictions for the future behaviour of markets extremely uncertain. Psychological reactions to short term events (including climatic disturbances) may influence outcomes entailing very different consequences than those anticipated by economists.

 

The interconnection of the economies of nearly all countries, whether industrialised, emerging or underdeveloped, reinforces the case for closer cooperation and coordination between actors. Indeed the unforeseen domino effect of any unilateral action (raising or cutting interest rates, administration of exchange rates, undue influence on the production and/or flow of commodities (oil), significant changes in investment patterns by Sovereign entities or private speculators etc.) could individually or cumulatively lead to the unravelling of a situation over which authorities would loose control.

 

While undoubtedly, responsible behaviour is necessary by all market participants, public and private alike, this can only be expected if the private sector is satisfied that authorities are working hand in hand towards common objectives. It is also the precondition for limiting second round effects that aggravate inflationary pressures.

 

The crisis of Fannie Mae and Freddie Mac, and particularly its global implications, demonstrated the dependence of the United States on factors outside of its direct control. It therefore becomes imperative to create a multilateral mechanism to monitor and coordinate the economic and financial policies of the major actors. In the same way that avoiding a systemic financial crisis is in the overwhelming common global interest, it would be equally foolhardy to believe that brinkmanship, fear and ultimately blackmail can allow a single power to set the agenda, reminiscent of worst periods of the “equilibrium of terror” that prevailed during the cold war.

 

To the contrary, the success of such an understanding could pave the way to further multilateral cooperation in fields such as the brokering solutions to geopolitical conflicts or improving the living conditions of world’s most destitute people.

 

 

 

 

 

Brussels, 8th September 2008

 

Paul N. Goldschmidt

Director, European Commission (ret.)

 

 

 

 

 

 

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