The US treasury’s bailout of state-sponsored agencies, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Association (Freddie Mac), is a sign that the credit crisis is far from being over.
Illustration: Jayachandran / Mint.
This is the second time in four months that a US financial institution had to be bailed out, the earlier case being Bear Stearns in March. The stocks of the two mortgage refinance institutions fell to levels last seen 15 years ago on concerns about their bearing the brunt of the exposure to plunging US house prices, since the institutions together back about half of all outstanding home loans in the US.
Because securitized debt issued by these two agencies is held by many banks and financial institutions, allowing these agencies to fail would have had a domino effect, the consequences of which would have been alarming. Moreover, many central banks also hold securities issued by these agencies on the implicit understanding that they are backed by the government and allowing the mortgage institutions to fail would severely undermine the credibility of the US and the dollar. There was thus never any question of these institutions being allowed to go under.
Nevertheless, questions about banks becoming “too big to fail” and, therefore, inviting moral hazard are once again being asked. Why, ask the critics, should the agencies and those who run them benefit so much from the mortgage boom, but not suffer the consequences of their acts during the bust? Is all the big talk about market discipline only for small businesses?
Questions are also being raised about the quasi-government nature of these institutions, with one line of criticism being that if the government has to underwrite them, they might as well be nationalized. The policy of socializing losses and covert nationalization through loan and equity support is seen to be hypocritical. And finally, there are those who point to the mortgage bubble as being induced by the US Fed and other central banks having kept interest rates artificially low for a very long time, and argue that the world economy needs to go through a bout of deflation to correct those excesses.
There are elements of truth in all these. Perhaps a via media should be found which, while protecting the institutions, penalizes the managers who contributed to the mess. However, a house on fire spells the urgency to douse the flames. US treasury secretary Henry Paulson would hope the assurance of state intervention is enough to enable the mortgage institutions to tide over the emergency. But, while the instant crisis may pass, as long as the US housing market continues to deteriorate, it will be a source of weakness for credit markets and asset prices.
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