Jeremy Warner's Outlook: Bailing out markets comes with the territory for American policymakers
Tuesday 09 September 2008
When the Americans act, they tend to do so with conviction. An already formidable US policy response to the unfolding banking crisis has been topped off by a bail-out of the country's two largest mortgage organisations, Fannie Mae and Freddie Mac, of quite breathtaking proportions.
Government intervention in the mechanics of free markets doesn't come any bigger than this, and though the debate is going to rage long and hard over whether it was the correct thing to have done, or whether it will merely store up even worse problems for a later date, in the short term at least, we have much to be grateful for.
The consequences of allowing these two linchpins of the US mortgage market to fail would not have been confined narrowly to the American economy, but would have had catastrophic consequences for the global financial system as a whole and thereby very likely plunged the world into deep recession. China and India may one day overtake the American behemoth, but for the time being it remains the case that when the US catches cold the rest of the world gets pneumonia.
Unlike previous, undercooked, US government initiatives to revive confidence in the mortgage-backed securities market, this time around Hank Paulson, the US Treasury Secretary, has thrown the entire weight of the Federal arsenal behind the endeavour. If this fails, then possibly we are indeed doomed to another Great Depression. Much more plausible, however, is that it provides the beginnings of a cure.
Compared with what Mr Paulson announced over the weekend, the £1bn housing package unveiled by the UK Government last week looks almost ridiculously inadequate. Rather than the ineffectual attempt to treat the effects of the housing crisis we've had in Britain, the US administration has gone for its root causes. The two organisations are getting up to $100bn of fresh capital apiece to address the growing short-fall between assets and liabilities, while the US government stands ready to underpin confidence in the mortgage-backed securities market by buying mortgage assets.
The detail is not entirely clear, but on the face of it the facility is virtually limitless and applies both to already trading mortgage-backed securities issued by Freddie and Fannie and to new ones issued against fresh mortgages. The always implicit government guarantee of bonds issued by Freddie and Fannie has been made explicit. More than £5 trillion of accumulated mortgage finance has become fully underwritten by the US taxpayer, while the organisations that sponsor this finance have in effect been nationalised.
The Republican Bush admin-istration must have had to swallow hard to embark on such root-and-branch intervention. All its free-market principles seem to have been thrown to the winds. Yet in truth, it is doing no more than conform to the grand tradition of American bail-outs of the financial system.
One of the key characteristics of free market capitalism, as Karl Marx correctly identified, is that it is subject to repeated crisis. The US is culturally much better at understanding this than the Europeans. Despite years of liberalisation, American markets remain some of the most highly regulated in the world and, when they fail, it remains widely understood that the state stands ready to break their fall.
There's plenty of moral hazard implicit in such underpinning of markets, for the effect must be to encourage excessive risk-taking. But it also underpins confidence, a commodity which is utterly vital to the smooth functioning of the free market system. When confidence goes, the whole thing falls apart, as we have seen over the past year. Re-establish that confidence, and everything is fine again.
From the moment the enormity of the crisis became apparent, both the Federal Reserve and the Federal Government have indicated through words and deeds that they will do almost anything to hold the waters at bay. Nobody can predict the future, but on the face of it, they seem to be succeeding.
Spreads on US mortgage debt were already narrowing yesterday, bringing the hope of both cheaper and more plentiful mortgage debt. This may not necessarily stop the US slide in house prices in its tracks. Once the psychology of falling house prices sets in, it's hard to tempt the buyers back to market, even when the finance returns.
Even so, this weekend's rescue lays the foundations for an eventual bottoming out of the housing market and therefore an end to the credit crisis. As long as house prices keep falling, it is impossible to have any faith in the value of mortgage-backed securities.
But if a floor can be established, then it should also stabilise the market in mortgage-backed securities and therefore reopen the funding taps. Once everyone knows that the meltdown in value has been stemmed, this in turn ought to bolster confidence in the banking system by making its capital ratios seem more robust.
There is also a positive read across to the UK housing market, where the fall in prices has been instructed by the same funding famine as has occurred in the US. Perhaps as much as a half of wholesale funding of the UK mort-gage market used to originate from the US. If US money market invest-ors return to American mortgage-backed securities, they might in time start investing here again too, albeit in a likely much reduced form.
Should the British Government be doing the same thing as the US in attempting to kick-start the UK mortgage market? Up to a point it already is, through the "Special Liquidity Scheme" (SLS). Already an estimated £80bn to £100bn of mortgage-backed securities have been bought through the scheme. The Government has yet to decide what to replace it with when it comes to an end next month. A "son of SLS" will emerge in some shape or form, yet it would almost certainly be a mistake to make it as all-embracing as what is being done for Freddie and Fannie.
The US system of financing mortgages has both encouraged reckless lending and, through the implicit Federal guarantee of Freddie and Fannie securities, been in effect taxpayer-subsidised. In both regards, the system has been found to be unsafe. Nobody would want to recreate such a monster, which is only being kept alive because of the catastrophic consequences of allowing it to die.
Quite how the next administ-ration is going to wean America off the drug of state support for mortgages is anyone's guess. Mr Paulson calls it a challenge for his successor. It's quite a mess that he's leaving him. But whatever the answer, we surely don't want to repeat the addiction here, where mortgages are not state-subsidised and where the originator of the loan is also responsible for the liability in the event of default.
It might be argued that we are already half way there with the nationalisation of Northern Rock and the creation of the SLS. But that's no reason to go the whole hog. The scale of the US bail-outs is almost bound to have inflationary consequences, and by creating moral hazard, will sow the seeds of the next boom-and-bust cycle. It's not what the beleaguered Brown Government wants to hear, but, for Britain, toughing it out may be the better option. As for the US, it looks as if the country that gave the credit crunch to the world will be first out of the downturn.
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