Hank to the rescue

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Sep 11th 2008
From The Economist print edition

The bail-out of Fannie Mae and Freddie Mac was inevitable. It may not be the last

Illustration by Claudio MunozIF HANK PAULSON had not already lost all his hair, he would surely be tearing it out right now. America’s treasury secretary must have thought saving Fannie Mae and Freddie Mac, the government-sponsored housing enterprises, would restore confidence to the financial system. But the stockmarket rally lasted just one day, before investors switched their worries to Lehman Brothers, a struggling investment bank.

Mr Paulson should get some credit for his rescue. The businesses had to be propped up to avoid chaos in the housing market; Fannie and Freddie have been providing around 80% of American mortgages this year. By taking the lead, the Treasury took the pressure off the Federal Reserve. Quite rightly, the “conservatorship” structure has ensured that the chief executives went and the shareholders suffered. Inevitably, bondholders (which include foreign central banks) have been protected; the government had promised as much and a debtor nation could not afford to antagonise its lenders.

In our view, the pair should have been nationalised back in July, and the new scheme should have had a clearer plan to shrink or break up Fannie and Freddie, so that they never again hold the taxpayer hostage (though not right now, because of the ailing housing market). Cuts will not occur until 2010—a reprieve that leaves the door open for Congress to put its clunking foot through. In the past Democrats have blocked plans to restrain the two agencies. Then there is the new fund that will buy mortgage-backed securities in order to support the market. The first purchase will be just $5 billion, but it is a worryingly open-ended commitment. Once begun, purchases will be hard to stop; the government will be tempted to send good money after bad. This sets a disturbing precedent: if the government can buy mortgages, why not credit-card or car loans? And if it can spend billions rescuing Fannie and Freddie, why not General Motors or Ford?

Relief rally
Stockmarkets at first welcomed the deal. The meltdown of Fannie and Freddie would almost certainly have led to financial chaos. By lowering the funding costs of the two agencies, the rescue should also bring down mortgage rates for hard-pressed householders.

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Although the plan has forestalled Armageddon in the American housing market, it is no cure-all. There are some signs of stability, but too many homes are for sale and defaults are rising fast. More than 9% of all single-family homeowners with mortgages are now a month in arrears or facing foreclosure. House prices may well fall further.

In any case, the credit crunch is no longer just about American housing. In Britain, Spain and Ireland house prices are falling. Defaults are rising across a range of debt classes from commercial property through corporate bonds to consumer loans. With unemployment rising in America and economic weakness ever more pronounced in Europe and Japan, economists are arguing about what counts as a recession (see article).

The credit crunch had its origins in finance. But the banking industry and the economy are now locked in a kind of negative symbiosis, where bad news in one induces pain in the other. Defaults cause bankers to restrict the availability of credit, which causes more defaults. And so the malaise spreads.

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The next test of the system is already here. Banks have spent the past year shoring up their balance sheets but, after some big losses, investors have lost their appetite for more share issues. Shares in Lehman Brothers have plunged as the investment bank tried, without success, to find an outside investor, leading the company to bring forward its results and its own emergency plan. If that fails, will the government be forced, as with Bear Stearns, to engineer a takeover by a rival?

It might be good, in theory, to let an investment bank fail “to encourage the others” and to buff America’s tarnished reputation as a champion of free markets. But having gone to such lengths to boost confidence in the financial system, the authorities will be reluctant to take that risk. It does not help that financial products are now so complex that it is very hard to make even an educated guess about the real value of a bank.

The world economy may well muddle through, as it has so often in the past. Growth in much of the developing world is still strong. And the recent fall in commodity prices, although partly sparked by economic fears, should be a boon. But the rescue of Fannie and Freddie and the travails at Lehman are merely the latest in a long series of tests that the authorities will have to face over the next year or so. With Fannie and Freddie, they eventually passed the test. They may have to act more quickly and decisively next time.