Rescue for Fannie and Freddie

US TREASURY secretary Hank Paulson vowed in July not to take into public ownership Fannie Mae and Freddie Mac, the two biggest…

US TREASURY secretary Hank Paulson vowed in July not to take into public ownership Fannie Mae and Freddie Mac, the two biggest privately owned providers of finance to the American housing market.

In an effort to calm financial markets at that time, he pledged government support - using taxpayers' money - to keep both companies in private hands and won Congress approval to do so. This promise of financial support, Mr Paulson hoped, would reassure and calm markets. "If you have a bazooka in your pocket and people know it, you probably won't have to use it," he added. On Sunday, however, he was forced to fire his bazooka.

The US government's action in taking over the two giant mortgage lenders amounts to an effective nationalisation of both companies. For, as the treasury secretary explained, a failure of both Fannie and Freddie "would cause greater turmoil here at home and around the globe". Undoubtedly, this pre-emptive move has reduced the risk of a financial meltdown in the US adversely affecting global markets and precipitating a world recession. In the circumstances, Mr Paulson had little choice but to act.

Fannie and Freddie were too big to fail but not too big to save. In what could become the world's biggest financial rescue, the takeover means the US government has assumed more than $5,000 billion (€3,500 billion) in liabilities. That is some 25 times bigger than the liabilities assumed by the British government when it took over Northern Rock. The nationalisation of Fannie and Freddie has left American taxpayers exposed to a huge future cost, unknown and unquantifiable.

READ MORE

That said, the vast majority of loans held by the two institutions are not at risk of default. On speculative estimates, the cost of the bailout may range from tens to hundreds of billions of dollars. How much the American taxpayer pays will be determined ultimately by the success or failure of the government's attempt to revive the housing market by taking control of Fannie and Freddie. The scale of the challenge is reflected in the housing statistics. During the second quarter of 2008, a record 1.2 million US homes were in foreclosure. These accounted for 3 per cent of all outstanding loans, a doubling on the same period a year ago.

Undoubtedly, a positive effect of the US government's action has been to lift a dark cloud of uncertainty that has hung over global financial markets, increasingly worried in recent months about the viability of Fannie and Freddie which guarantee over half of all US mortgages. Relief at the bailout was reflected in a rally in global stock markets, notably among financial stocks, with Irish bank shares yesterday making a strong recovery.

The problem with Freddie and Fannie has been their unusual financial structure and hybrid nature as privately owned but "government-sponsored enterprises" which enjoyed implicit government backing. As both private and public entities, the rewards for shareholders came from maximising profits. But the risks arose for taxpayers who - as we now see - were required to rescue a private company regarded as too big to fail.