Calling time on crony capitalism

SERIOUS MONEY:THE WORLD'S financial markets got off to a shaky start this month as the credit crisis showed few, if any, signs of abating, writes Charlie Fell.

Investors were delivered a much-needed reprieve last Sunday after the announcement by US Treasury secretary Henry Paulson that Fannie Mae and Freddie Mac were to be placed in conservatorship.

There were hopes the largest government bailout in history would erase some of the heavy losses they incurred in the year to date. However, the ebullient market reaction on Monday failed to propel aggregate stock prices beyond their 50-day moving average. Just one day later, all of the gains were erased as the failure by struggling investment bank Lehman Brothers to secure a capital injection from the state-run Korea Development Bank reminded investors that the credit crisis extends far beyond the mortgage market.

The bailout of Fannie and Freddie was only a matter of time. The companies had combined losses of almost $15 billion (€10.64 billion) in the year to June 30th. That reduced their capital bases to razor-thin levels, but their importance to the US mortgage market ensured bankruptcy was never an option.

Fannie and Freddie between them own or guarantee almost half the $11 trillion in outstanding debt and have been instrumental in keeping the primary mortgage market open through the purchase and provision of guarantees on roughly 70 per cent of all new US home loans.

They have kept the secondary market alive through the credit crisis, with the value of their mortgage assets increasing by almost $600 billion since last summer, compared to a decline of more than $150 billion at private lenders. The failure of either company would have sent the already depressed housing market into a tailspin as mortgage origination dried up and liquidity in the secondary market vanished.

The US Treasury had no option but to open its balance sheet to Fannie and Freddie just as the Federal Reserve did for Bear Stearns earlier in the year. Its plan includes a capital injection of up to $100 billion for each company, a credit facility and the creation of a government-backed investment fund that would purchase their debt securities.

These measures should bolster market confidence and prevent further deterioration via lower mortgage rates and greater availability of new loans. The plan, however, is only the first step on the road to credit market rehabilitation and will do little to prevent the necessary deleveraging process that is already in train or ease the strains across other markets.

Nor will the plan unleash pent-up housing demand as it simply doesn't exist, given that the home ownership rate is still too high against historical norms and the demographic profile is unfavourable, with the average baby boomer in their 50s.

Furthermore, it will not prevent foreclosure. Many people struggling with mortgage payments may lose their jobs and will have little option but to default. The credit crisis was not confined to the mortgage market and is evident across most debt securities. The global decoupling thesis has also proved fanciful, as recession is almost assured for the G7 industrialised nations.

Paulson's action was necessary, but is not sufficient to end the turmoil. He advised that senior management were to be removed from office, but his comments that they were blameless is wide of the mark. He seemed to suggest the inherently flawed business model destined Fannie and Freddie to conservatorship.

While this may have contributed to excessive risk-taking, it was surely management's reckless behaviour that brought the companies to their knees. The same can be argued of investment managers who put forward many excuses to justify the substantial damage they inflicted on pension funds over the past year.

They argued that the subprime problem would be contained and aggressive monetary easing by the Fed alongside robust economic growth elsewhere would sustain the cyclical bull market. The whimsical theories proved incorrect, only for the so-called experts to turn their attention to high oil prices as a justification for the market's muted response.

The credit crisis was supposedly unforeseeable, but the clues were easy to spot more than a year ago. Warning signs included the massive credit expansion of recent years, the surge in house valuations to almost three standard deviations above historical norms and the proliferation of subprime mortgages alongside deteriorating lending standards.

Unfortunately, the professionals were too busy listening to the investment houses that had a vested interest in perpetuating the boom.

Investment managers had numerous opportunities during the downturn to adjust allocations, but chose instead to maintain high equity weightings. Some even raised their exposure, despite the mounting evidence that argued against such action.

The flawed analysis has seen some pension funds lose more than a quarter of their value over the past 15 months, yet those responsible continue unfazed.

Paulson has called time on the crony capitalism evident at Fannie and Freddie. Pension fund trustees should take note and act accordingly.