Sean O'Grady: The world depends on the two Fs

Monday 08 September 2008 00:00 BST
Comments

Your support helps us to tell the story

From reproductive rights to climate change to Big Tech, The Independent is on the ground when the story is developing. Whether it's investigating the financials of Elon Musk's pro-Trump PAC or producing our latest documentary, 'The A Word', which shines a light on the American women fighting for reproductive rights, we know how important it is to parse out the facts from the messaging.

At such a critical moment in US history, we need reporters on the ground. Your donation allows us to keep sending journalists to speak to both sides of the story.

The Independent is trusted by Americans across the entire political spectrum. And unlike many other quality news outlets, we choose not to lock Americans out of our reporting and analysis with paywalls. We believe quality journalism should be available to everyone, paid for by those who can afford it.

Your support makes all the difference.

"Too big to fail" is an expression that suits Fannie Mae and Freddie Mac. The US Treasury Secretary, Henry Paulson, said yesterday that the two institutions "are so large and interwoven in our financial system that a failure of either of them would create great turmoil in financial markets".

He was right. He might even have been understating things. For if Freddie and Fannie had been allowed to go under, the credit crunch so far would have been a mere prelude to a much more profound slump – one comparable to the Great Depression of the 1930s, the last time the banks stopped lending. Global financial turmoil would have been the start.

This is not hyperbole. It is terrifying to contemplate what the collapse of the (assumed) guarantees behind $5.3trn of US mortgages might have led to. Fannie and Freddie acted as middlemen between US banks, lending cash to homebuyers, and the investment community wanting to buy mortgage-backed bonds.

For decades, Freddie and Fannie took the banks' mortgage books and sold them on to investors looking for steady returns. They had been privatised long ago but their traditional links with government and their size made many assume the government backed them, with an assurance and a yield close to that attached to a US Treasury bond.

The status of Freddie and Fannie was always a tad unclear but that suited all sides. Borrowers could obtain cheaper funds (the safety of the US Treasury meant investors would accept a lower interest rate) and investors had never seen, nor imagined, a default on a Freddie or Fannie bond. Take that confidence away and you would engineer a further collapse in the US property market, more defaults and more foreclosures.

And in the US, unlike here, these are "non recourse" – when you hand the house keys to the bank you can walk away from the debt. Great for foolish homebuyers – not so much for banks with burgeoning bad debts, which in turn makes them unable to lend. And that is bad news for the economy, for jobs and, in a vicious circle, for the real estate market.

The vast quantities of Fannie and Freddie bonds held in just about every life insurance and pension policy and bank balance sheet across the globe would have been effectively trashed, creating more damage to the financial system and to the global economy.

For a lame-duck administration this is a bold move. Financially and politically it is on the scale of the bail-outs for the City of New York and the Chrysler Corporation under Ronald Reagan and the vast extensions of federal power during the Franklin Roosevelt era.

Ironically, it was the last serious US housing slump that led Roosevelt to establish Fannie Mae as a government agency in 1938. It is strange that, in the home of free enterprise, the state should again have to come to the rescue. But when you're too big to fail ...

Join our commenting forum

Join thought-provoking conversations, follow other Independent readers and see their replies

Comments

Thank you for registering

Please refresh the page or navigate to another page on the site to be automatically logged inPlease refresh your browser to be logged in