Crumbling Foundations

Crumbling foundations


With the mortgage giants Fannie Mae and Freddie Mac tottering and anxious depositors queueing to withdraw their money from a failed bank, the housing-driven credit crisis in the United States came home to Main Street this week. But analysts say the worst is yet to come. Anne Davies reports from Washington.

IT's the stuff of every banking regulator's nightmare: angry mobs outside a bank demanding their money. It became reality on Monday this week as customers queued outside the failed IndyMac Bank in California, after the Federal Deposit Insurance Corporation took over its operations and reopened for business. At one branch in the San Fernando Valley, police were called as the long lines of people waiting to reclaim their deposits became impatient.

Last Friday's collapse was the third biggest in US history, but certainly not the first in recent times. Why then, was there such panic in the air?

On the other side of the country in Washington, the banking regulators were busy going public on their latest rescue plan for the US banking system, but it was not IndyMac they were worrying about.

Last Saturday the US Treasury and the Federal Reserve held urgent talks to stabilise Freddie Mac and Fannie Mae, the two biggest players in the secondary mortgage market. Compared with IndyMac, which is an ordinary retail bank, Freddie and Fannie's problems were of an entirely different order.

That's because they are the grease in the US mortgage market. Set up during the Great Depression to try to make housing more affordable, they hold or guarantee 50 per cent of the $US12 trillion ($12.36 trillion) in mortgages in the US. Their business is to buy mortgages from the retail banks and mortgage brokers who write the loans, package them up into securities and sell them to investment banks and investors from Wall Street to Sydney. This frees up the brokers and banks to lend more money.

For this service, Fannie and Freddie earn fees. But their big advantage is that, although they are now listed companies, they were originally set up by the government and still have an implicit government guarantee, enabling them to borrow money more cheaply.

In short, they make the US mortgage market go round.

But with the subprime crisis still unfolding and foreclosures now likely to claim more than a million homes this year, shareholders in the two companies had become extremely nervous about their potential exposure. Shares fell sharply, raising questions about the companies' capitalisation and their ability to get away a bond issue, scheduled for early this week.

It was all hands to the pump. The Treasury Secretary, Hank Paulson, the Federal Reserve chairman, Ben Bernanke, and even President George Bush went public to sell the rescue package to the markets and to Congress.

Fannie Mae and Freddie Mac "represent the only functioning secondary mortgage market," Paulson told the Senate banking committee on Tuesday.

"Our plan is aimed at supporting the stability of financial markets, not just these two companies."

Bernanke said the two companies were in "no danger of failing". Actual credit-related losses at Fannie and Freddie have been relatively small. In the first quarter Fannie Mae reported $US3.2 billion of credit-related expenses, mostly provisions for expected losses on mortgage defaults. That is a fraction of the $US3 trillion of mortgages Fannie owns or guarantees.

The issue, Bernanke stressed, was about their share price, and whether they faced future problems in raising capital. If they were unable to raise capital, the mortgage market could grind to a halt, because the securitisation process packaging loans and then selling them to investors so they can write more loans would falter.

Put like that, a rescue seems logical. But the dramatic intervention - following the rescue buyout of Bear Stearns engineered by the Federal Reserve in March and emergency lines of credit put in place for other major investment banks in May - has again raised questions.

How is it that the regulators did not see this coming? Has deregulation failed the American public? Why are US taxpayers being asked to bail out the top end of town when thousands of people are losing their houses every day? And lastly, the big question: where the hell is the US economy headed?

There is already a big rethink under way about the cost of deregulation. So far, efforts have focused on the regulation of mortgage practices at one end (fraud on the part of mortgage brokers appears to have been widespread) and new rules to try to prevent the rampant short-selling of shares at the other.

Treasury has produced a discussion paper on streamlining the multiplicity of regulators for its financial sector, but for the time being the preference has been for greater oversight in the crisis rather than regulation.

That might be about to change.

William Galston, a senior fellow at the think tank Brookings Institution, says the US is at a hinge point.

"The strong presumption in favour of markets, which has dominated public policy since the late 1970s, has been thrown very much into question," he said.

For example, the US has been happy to have insurance for banks that go under - with account holders getting up to $US100,000 back on their deposits - rather than taking the Australian approach of setting prudential limits on banks and in return providing a government guarantee on their deposits. A few bank failures, plus a consumer backlash about lost funds over and above $US100,000, is likely to cause a rethink.

The head of the House of Representatives' banking and finance committee, Barney Frank, says its already under way.

"Ben Bernanke is reversing a policy of Alan Greenspan," he said this week. "Greenspan had the authority under a congressional statute from 1994 to take action to ban irresponsible subprime mortgages. He refused to do it because of his anti-regulatory theory. Bernanke is promulgating those as we sit here, so that, going forward, you are going to see some of the subprime mortgages, many of them that got us into trouble, banned."

Then there is the question of who, morally, should bear the cost of failure.

Paulson's actions in propping up Fannie and Freddie, the big daddies of the mortgage market, with promises that American taxpayers will buy their shares and lend them money if needed, has again raised questions about the principle of moral hazard - and even allegations of helping mates.

Paulson was head of the investment bank Goldman Sachs before he became Treasury Secretary. The former chairman of Fannie Mae, Jim Johnson, was head of Goldman Sach's remuneration committee, where he helped set Paulson's healthy salary.

But the bigger question is: if the Government and taxpayers bail out market players, how do they learn the lessons of mistakes?

President Bush's former economic director Lawrence Lindsey, now a financial consultant, was so incensed by Paulson's intervention that he wrote to clients saying: "Surely things are somewhat amiss when a country's finance minister plays bond salesman for a supposedly privately owned company."

As for where it is all going, the big problem facing US regulators is that no one can really anticipate where the next problem will emerge in their deregulated and complex financial system, only to ripple through the sharemarket, credit markets, manufacturing sector and then into the global market.

And that makes people jump at almost any rumour.

Even big banks like the Bank of America are being wildly marked up and down. Its share price has gyrated 40 per cent over two days.

Bernanke insisted this week that the US banking system was "well capitalised", although he added that he was watching the situation closely. He said he was more concerned about the banks' ability to extend the credit the economy needed to keep growing.

Commentators believe a few smaller banks will go under but do not think there will be a wholesale collapse in the sector, as occurred in 1929. Bush, who rarely does press conferences these days, appeared in the Rose Garden at the White House to repeat the message that the banking sector was sound.

But taking a step back, it is pretty clear the worst is not yet over.

Most analysts agree that the subprime crisis has a way to run. The number of mortgages in default at the end of June was 631,000, up from 313,000 a year ago. But the really scary number is that about 1.5 million subprime loans are still scheduled to "reset" this year. That is when the interest rate jumps 3 to 4 per cent and home owners find their repayments increase by 30 to 40 per cent.

Lawrence Summers, a Treasury secretary in the Clinton administration, has predicted there will be more than 2 million foreclosures over the next two years and that as many as 15 million home owners will owe more than their houses are worth.

That has enormous implications both socially and economically.

The big waves of foreclosures are still driving down house prices as banks, worried about the backlog of stock, slash prices to get sales away. That then helps drive down the price of neighbouring houses. As of March, the S&P/Case-Shiller national home-price index had fallen about 16 per cent from its peak in the second quarter of 2006, but this average masks the severity of the downturn in some markets.

Prices in California were down about 29 per cent over the same period, and there are dozens of anecdotal stories about four-bedroom houses bought for $US1.5 million in 2006 in places like Scottsdale, Arizona, now selling for $US855,000.

"House-price declines are at the root of all our economic and financial problems," says Mark Zandi, chief economist at Moody's Economy.com and author of Financial Shock, a new book about the collapse of the subprime mortgage market.

"Investors can't tell where the bottom is or how far mortgage-related assets have to be written down. That's shaking even blue-chip institutions like Fannie and Freddie."

There are other storm clouds on the horizon for the US economy as well.

The credit drought is starting to hit small business, freezing expansion. Consumer spending is slowing. Despite $US152 billion being pumped into the economy by way of a stimulus package last month, consumers have cut their spending, especially on expensive items like cars and furniture.

Bernanke said this week it was not as bad as it could be, and that retail spending and rising exports were keeping the economy moving at "a sluggish pace".

But not fast enough for some companies. General Motors announced this week that it would cut 20 per cent from its costs, and analysts say as many as 6000 US jobs could go.

Unemployment has risen from 4.6 per cent a year ago to 5.5 per cent last month, and will only exacerbate the housing market problems at the heart of America's economic woes.

As the week came to an end, economists around the world were left pondering how the next chapter in the wild ride in the US financial system might play out.

A fall in oil prices this week caused a rally in global sharemarkets and brought a few smiles to traders' faces.

But oil and food prices remain high, fuelling inflationary pressures around the world as well as in the US.

In further evidence that energy prices are hurting the US economy, consumer prices rose 1.1 per cent last month, the biggest rise since 1982, taking the annualised rate to 5.5 per cent.

That presents the Federal Reserve with a dilemma: to focus on the threat of inflation and increase rates, or keep them low to keep the economy moving.

In past eras bad lending practices by mortgage brokers in the suburbs of California or Florida might have felt like a domestic issue. Now we are learning that bad loans in Florida have ramifications in China, Europe and Australia.

We are learning that a policy to help Iowa corn farmers turn corn into ethanol will have implications for a poor village in Mexico or Africa, and that blind faith in markets can send the entire world into financial chaos.

That is why, over coming weeks, every sneeze in the US markets will be monitored worldwide. Perhaps the US regulators can steer the global economy away from the reefs that lurk beneath the surface in coming months. But no one, not even Bernanke, is entirely sure.