The upbeat response to the Fannie and Freddie bailout was short-lived, showing fundamentals remain bearish, writes Arthur Beesley

THE DISRUPTION continues. More than a year after the seizure in credit markets brought the international banking system to a virtual halt, the US government rescue of wholesale mortgage providers Fannie Mae and Freddie Mac marks a new turn in a creeping financial crisis that still seems far from its conclusion.

The three-pronged federal rescue package includes cash injections of up to $100 billion (€71.7 billion) in each of Fannie and Freddie, giant-sized government-sponsored enterprises whose business model dates to the time of Franklin D Roosevelt. In addition, the government will buy their mortgage bonds and provide them with backstop liquidity support of unlimited size.

Be he Barack Obama or John McCain, the next occupant of the White House will have to carry the operations of two troubled companies, whose combined liabilities amount to some $5.4 trillion, on the books of his administration.

But with the totality of write-downs throughout the global system since the crisis began now exceeding $400 billion, US Treasury secretary Hank Paulson stressed that an outright public rescue of Fannie and Freddie was required to avert devastating consequences should they fail.

"Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe," said Paulson, a former chief of Goldman Sachs who brought full-blooded free-market credentials to the Treasury when sworn in two years ago.

Much has changed since then. Amid increasing doubt that Fannie and Freddie could survive in light of their weakening financial position, the rescue last weekend came only two months after Paulson said he had no plans to intervene. Loss of confidence in the companies, however, was such that his options narrowed by the day.

"For me, the Freddie Mac and the Fannie Mae intervention is positive in the sense that it brings more certainty into a very uncertain world from a global perspective," says Smurfit Kappa chief Gary McGann, whose company has a big exposure to international capital markets via its debt.

"The global stock market reaction to that is probably in many ways proof positive of that, in that it was seen as a positive. I'm not sure people intellectualised it extensively. The sentiment was a positive one and it took a huge degree of uncertainty out of paper that was obviously rattling around the total international financial system."

Markets rallied alright. Yet within hours the upbeat response was tempered by growing uncertainty about the fiscal position of investment bank Lehman Brothers, now teetering between collapse and survival after efforts to raise an investment from Korea Development Bank ran aground.

That such a colossus of Wall Street, in business since 1850, should be brought to the brink of the abyss for want of a capital infusion from an arm of the Korean state underscores how long-held certainties of the old capitalist order have seeped away.

Lehman's pursuit of the Seoul-based bank is in line with other Wall Street luminaries such as Citigroup, Morgan Stanley and Merrill Lynch, who have boosted their balance sheets with capital from government funds in Singapore, China and the United Arab Emirates. Having failed to deliver the Korean deal, Lehman rushed out a survival plan that involves the sale of its lucrative asset management unit and the spin-off of troubled property assets.

"It doesn't seem on the basis of the share price response yesterday that people are convinced that Lehman [will come] out of this," says Gary McCarthy, managing director in Dublin for investment bank Collins Stewart.

"In the last month you've had some pretty horrendous news in the sense that, when a country chooses to nationalise 80 per cent of its mortgage market, that's pretty big. That's Fannie and Freddie's current market share. If you think back to Northern Rock, that was only 10 per cent."

Nor did the fallout stop at Lehman's door. As investors surveyed the scene for the next-weakest link, shares in US regional lender Washington Mutual came under severe pressure amid fears that it would soon run out of time to shore up losses from subprime loans and credit-card lending.

With volatility now the norm in international markets, the sequence of events this week demonstrates how this long-running crisis moves quickly from institution to institution as new problems emerge into the open.

"What you're seeing is, in a way, part of a continuation . . . of what we've had for the last six or nine months, which is a huge concern on the one hand and a huge distrust on the other hand that people actually understand what the bottom of this means and where the bottom lies and how close to bottoming out we really are," says McGann.

"Until people get over that hump I think what you're going to see is periods of almost irrational optimism at any port in a storm. You can see clearly that there's an appetite for wanting to believe things are turning and getting back into sort of positive mode again, but when people get behind the fundamentals there's no belief that the bedrock has been reached to support that yet."

Thus the sense of uncertainty pervades. It seems an age ago, but only six months have passed since the US government-brokered rescue by JP Morgan Chase of Bear Stearns in a $230 million fire sale. Weeks before that seismic event, US Federal Reserve chairman Ben Bernanke introduced a supersized emergency interest-rate cut in an effort to stimulate economic activity in the face of threatened recession.

Such interventions and the rescue of Fannie and Freddie clearly illustrate the willingness of the US authorities to take action where necessary to stabilise the market. That's what regulators do, of course. What remains unclear, however, is the extent to which further action will be required.

"This is a necessary but not sufficient condition for global markets to recover, necessary in the sense that we knew something had to be done for Fannie and Freddie. But they are of course symptomatic of the underlying problem, which is the US housing market," says Richard Reid, chief European equities economist with Citigroup in London.

While there is greater clarity now about the true scale of the subprime problem, Reid says further dangers lie ahead given the macro-economic forces at work in the global economy. He cites signals from the European economy showing conditions there are worse than thought, and a shift in commodity prices "that's changing the balance of power" in the emerging world.

"We have this cyclical monster, which includes things like what's going to be the fallout for the banking system, and we're putting our hands around this monster in the dark and we just don't quite know how big this baby is," says Reid.

Already, the financial world is braced for yet more losses. In July, for instance, the International Monetary Fund (IMF) warned that net bad debts arising from the crisis were likely to reach $945 billion, a forecast deemed conservative in some quarters.

Former IMF chief economist Kenneth Rogoff vividly described the risks ahead when he warned in recent weeks that the worst of the turmoil was yet to come.

"The US is not out of the woods. The financial crisis is at the halfway point, perhaps," said Rogoff, now an economics professor at Harvard University.

"We're not going to see [only] midsized banks go under in the next few months; we're going to see a whopper, we're going to see a big one, one of the big investment banks or big banks."

In rather more staid language, the European Commission warns that a combination of the financial crunch, the near doubling of energy prices, and corrections in some housing markets is having an impact on the economy.

"The global economic situation and outlook remains unusually uncertain," the commission said this week. "One year after the outburst of the financial turmoil, the situation in the international financial system continues to be fragile with several key credit markets still severely disrupted."

As the humbling of Wall Street proceeds apace, the Irish economy deteriorates rapidly. Workers in vulnerable industries face a threat to their jobs; banks are grappling with the falling property market; and business at large faces an erosion of consumer spending.

With an early budget on the way, was there anything in Paulson's action at the weekend to change the outlook for the Irish economy? "Last week [was] more about international sentiment," says McGann. "We're a small open economy so obviously international perspectives are very important aspects of our lives. It [draws] attention to the issues we have ourselves, even though they are somewhat different."

Abroad and at home, the roads ahead are rocky.