America banks it all on the biggest bail-out ever
US treasury secretary Henry Paulson (left), with Ben Bernanke, chairman of the US Federal Reserve. Mr Paulson's rescue package for Fannie Mae and Freddie Mac, announced yesterday, is at least 10 times bigger than any government intervention in any financial market anywhere in the world
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Is this then, finally, the 'Big One', the monster-sized upheaval, usually accompanied by some kind of government support operation, that normally marks the low point of every major financial crisis? In terms of scale, there can be no question.
The rescue of Fannie Mae and Freddie Mac, America's two dominant mortgage providers, announced yesterday by Henry Paulson, the US treasury secretary, is bigger by at least a factor of 10 than any previous government intervention undertaken in any financial market anywhere in the world.
In terms of size, these two government-sponsored enterprises (GSEs), whose legal status and ownership has always drifted ambiguously between the private and public sectors, have $5.2trn ( €3,700bn) of debt between them, making them bigger than the top 10 private banks put together.
Indeed, from the standpoint of the world's financial markets, the GSEs are comparable in significance to the US Treasury itself, which has dollars $5.49trn of publicly held debt.
For this reason, among others, there was never the slightest risk that anyone investing in the bonds of the GSEs would ever lose a penny. For the treasury to allow an iota of a doubt to persist about the GSE's ability and willingness to meet all their obligations would have been equivalent to defaulting on the US government's own debts.
Triggered
This would have triggered a liquidation of dollars on a scale unseen in history. Because everyone knew that the GSEs would continue to meet their obligations, they did not face any Northern Rock-style funding crisis. But in that case, why did the US treasury find it necessary to take yesterday's extraordinary measures and what do they tell us about the financial and economic crisis engulfing the US and the world economies?
Oddly enough, the first question is more difficult to answer than the second. The precise timing of the decision to guarantee Fannie and Freddie explicitly with taxpayers' funds was probably driven by politics and moral philosophy more than economics. The treasury's reason for choosing this weekend, rather than any other, was partly dictated by the US election cycle -- to avoid accusations of partisanship, the announcement could not be made during the political conventions, nor delayed until too close to polling day. The management of the GSEs had to be ousted not for reasons of financial incompetence but to demonstrate that the private shareholders represented by these managers were losing control of their companies in exchange for public support.
Meanwhile, the main opposition that the treasury had to overcome before mounting a support operation was not based on economic arguments. Instead, the objections were philosophical -- is it socially justifiable to use taxpayers' money to support companies that are legally in the private sector?
Would support for the GSEs create 'moral hazard' in the future by encouraging reckless behaviour by future generations of borrowers and bankers? Would government intervention undermine America's faith in free markets? Or did the 40-year existence of GSEs as public-private hybrids prove that America was already much further away from a pure capitalist economy than claimed by dogmatic free marketeers?
These are all interesting debates for the months ahead, but of greater immediate importance is what the GSE support operation implies for the current financial crisis.
And on this point the answer is clear-cut. Last night's announcement was unqualified good news for the US economy. It will eliminate a large source of financial uncertainty, reduce US mortgage rates, boost the availability of housing finance and strengthen the dollar by making absolutely explicit government guarantees on GSE debt.
Starting with the last point, Mr Paulson's announcement settles the question of whether or not the GSEs are government-guaranteed: "Fannie Mae and Freddie Mac securities are held by central banks and investors around the world. Investors have purchased securities of these enterprises in part because the ambiguities in their congressional charters created a perception of government backing. Because the US government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and mortgage-backed securities."
To make good on this promise, the treasury has made available an unlimited borrowing facility to guarantee liquidity to the GSEs and has entered into a legally binding contract to pump up to $100bn of new equity into each of the GSEs if their capital should fall below regulatory benchmarks.
"This commitment," in the words of Mr Paulson, "will ensure that the conserved entities have the ability to fulfil their financial obligations" regardless of whatever losses or writedowns they might suffer from the housing crisis.
Even more importantly for the US housing market, yesterday's package included an announcement that Fannie and Freddie will "moderately increase" lending. The treasury itself will start to buy mortgage-backed securities, increasing the availability and affordability of mortgage finance.
This new programme of mortgage lending will run until the end of 2009 and its scale "will be based on developments in the capital markets and housing markets" -- a strong hint of potentially unlimited government backing until conditions in the housing market are restored to normal. Reading this announcement, British housebuilders and mortgage lenders may be turning green with envy. Before they get too jealous, however, British bankers should note the pounds of flesh Mr Paulson extracted from Fannie and Freddie shareholders in exchange for this support.
All this really does add up to the biggest government intervention in any market economy since the World War II. If this programme is not sufficient to put the US economy and financial system back on its feet, it is hard to imagine anything else that could.
Anyone betting against this package is, therefore, betting that the US economy is doomed. Such a bet has always been wrong in the past and is likely to be wrong again this time. So yesterday probably was the Big One -- and a US economic recovery is now assured.(© The Times, London)
- Anatole Kaletsky
