Fannie and Freddie bailout underlines severity of credit crisis

ECONOMICS:ANOTHER SUNDAY, another US government bailout, and it probably won't be the last, writes Alan McQuaid

Rather than marking the turning point that assures an economic recovery, the support that had to be provided to US mortgage giants Fannie Mae and Freddie Mac last weekend simply underlines the severity of the ongoing credit crisis.

The bailout will help to avoid the worst-case scenario of a complete financial meltdown, but the outlook for the housing market and the wider economy remains grim. The US government's stunning takeover of Fannie and Freddie saves the mortgage giants' lives, but fails to determine what they will look like once they unplug from life support. The job of rehabilitating America's largest housing finance companies will fall to the next US congress and the next president.

Hours after Fannie Mae and Freddie Mac were placed under federal conservatorship by treasury secretary Henry Paulson, US housing experts were predicting a struggle next year over the ultimate fate of the government-sponsored enterprises, or GSEs.

Reform scenarios for Fannie and Freddie have been debated for years, ranging from nationalisation at one extreme to privatisation at the other. Taking into account next year's political changes on Capitol Hill and in the White House, chances for radical change in the next year or two may be remote. The Democratic Party is widely expected to keep House of Representatives control next year, while possibly increasing its narrow senate advantage.

A McCain administration could try to push through a radical change to the GSEs, but that would need to get through the Democrats in congress, and it is difficult to see that happening.

At the crux of the matter is housing and the economy. With mortgage default rates rising, markets have been losing confidence in the viability of Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgages from lenders and hold them or securitise and sell them on to investors. As demand for their paper diminishes, the cost of mortgages rises, putting more pressure on the housing market.

In recent months, foreign investors in particular have been shunning securities in both agencies, long viewed as nearly as safe as US treasury debt due to an implied government backing. Many investors believe the picture for the agencies could worsen with their third-quarter financial reports in the coming weeks, which are likely to show increasing credit losses and delinquencies from subprime and near-prime "Alt-A" loans.

Also, Fannie and Freddie are scheduled to roll over some $500 million (€360 million) in debt by the end of the month. That could go badly if markets lack confidence in the two institutions.

Despite this latest rescue plan, the US economy and financial system is not out of the woods yet. The Bush administration's willingness to pull out all the stops to support the financial system and the housing market was never really in doubt. Instead, this latest bailout underlines the fact that the crisis is lasting much longer (and is much more severe) than had been generally expected. It may simply shift the spotlight to those mortgage market participants not considered "too big to fail".

The bottom line is that the US housing slump will continue. Mortgage availability and affordability may well improve a little, but shrinkages in bank capital will leave them reluctant to lend and higher government bond yields will not help.

Indeed, ever since the credit crisis began the US government has been increasing its funding of the mortgage market by hundreds of billions of dollars via the 12 Federal Home Loan banks.

And financing is only one dimension of the housing slump. The massive overhang of unsold property and deteriorating economic fundamentals will maintain downward pressure on house prices. The worst-case scenario should be avoided, but the US economy is likely to contract in the second half of the year and grow below par in 2009.

One of the most interesting developments in the aftermath of the US bailout was the rally in the dollar. Some investors feared that the implied increase in the US federal budget deficit as a result of the rescue plan would weaken the greenback. Instead the dollar rallied, mainly on the view that US authorities were at least trying to do something to sort out the financial crisis and the economy.

The same cannot be said of the euro zone. Although it may have started in the US, the credit crunch is now a global event and the difficulties for Fannie and Freddie are a symptom of the crisis not the cause.

Despite increasing danger of recession, the European Central Bank refuses to cut interest rates as long as inflation risks becoming invasive. All this indicates, as ECB president Jean-Claude Trichet admitted in the past week, that the crisis could get worse in the euro zone.

This does not augur well for the Irish economy or Irish financial shares. Good reason, then, for the Government to take the initiative and unveil a fiscal stimulus package in next month's budget to try and kick-start activity again.

• Alan McQuaid is chief economist at Bloxham Stockbrokers