Beware the ides of the month. Just as Bear Stearns fell into the abyss around the 14 March before being rescued, the larger problems of Fannie Mae and Freddie Mac fell into their own black holes on 11 July, also to be rescued. Different problem, same rescuers. The US Government through the Treasury Secretary and his department and the US Federal Reserve.

And different animals. Bear Stearns was a poorly-run investment bank. Fannie Mae and Freddie Mac are two companies chartered by the US Congress to help finance the American home ownership dream. They are what are now called Government Sponsored Enterprises or GSE’s. Legally it’s a grey area. They are private companies acting under a US Congressional charter. In the eyes of the markets in the US and around the world, they are almost US Government-controlled and issue debt with the same rating.

And yet last week the market started treating them as being close to, if not insolvent.

The upshot is that the Fed will fund the day-to-day needs of the two mortgage giants, as it is currently doing temporarily for the investment banks, and has done since the Depression for commercial banks. If need be, the US Government will inject whatever is needed to recapitalise the two giants. Analysts last week suggested upwards of $US75 billion might be needed, on top of the $US20 billion already raised in new capital since late last year.

So in a dramatic 4pm Sunday announcement (in time to catch the start of trading in Tokyo this morning) Fannie Mae and Freddie Mac, the holders of $US5.8 trillion of America’s $US12 trillion mortgage market and the biggest entities in the US financial markets, were rescued by the US Government and Fed. Going much further than anyone had predicted, the US Treasury Secretary, Hank Paulson indicated he would seek blanket authority from the US Congress to aid the two struggling mortgage giants. He stopped short of outright takeover, for now.

The move came only hours before Freddie Mac had been due to sell $US3 billion worth of short-term debt, a move that would have tested whether or not the market wanted to support them. It’s now clear that the issue could have failed, thereby questioning the creditworthiness of the USA itself because debt from the two mortgage groups is regarded as being tantamount to US sovereign debt. The sale of that debt tonight becomes the test of whether the dramatic move to effectively take control of the two mortgage giants’ futures has worked and whether other investors accept the creditworthiness of Fannie and Freddie, and by extension, the USA.

To make sure, US media reports said the Treasury had been onto all major investors asking them to bid on the debt issue. It is going to become the major test of the credit markets and the crunch, and sentiment towards the US.

Paulson will ask the US Congress for a “temporary” increase of the companies’ lines of credit with the Treasury from the current $US2.25 billion each, and the right to buy equity “if needed.” The plan, if it is given congressional approval, would give Paulson power to buy an unspecified amount of stock in Fannie Mae and Freddie Mac. A third element of the proposal would give the Federal Reserve a “consultative role” overseeing the companies’ capital requirements.

The Fed also announced it will let the companies borrow directly from the Fed at the same discount rate as commercial banks. That means the Fed’s discount window has now been expanded to accommodate crippled and needy investment banks and the two huge mortgage groups, as well as the existing commercial banks, one of which was shut on Friday at a probable cost of up to $US8 billion to regulators.

There is an additional problem for the US and the world in the problems at these two giants: it’s an international perspective best summed up by, of all people, the Russian finance ministry. It said on Friday that Russia (which holds $US100 billion of US Government agency debts in its official reserves, including Freddie Mac and Fannie Mae debt) considers the agency debt as on a par with the debt of the US Government.

Other countries (China?) would have big holdings as well and they would not be expecting a sharp rise in losses on that debt to the point where it raised questions about its backing. The Freddie Mac and Fannie Mae problems raise enormous questions about the creditworthiness of the US, and there’s a geo-political side to the whole situation. The US can’t contemplate letting the two companies go broke: it would be tantamount to the US defaulting. So it’s then no wonder Secretary Paulson had this to say in his statement

GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure. In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.

You don’t get any message clearer than that: “maintaining confidence and stability in our financial system and our financial markets”. The financial markets of the world may have been pulled back from the brink for a second time in four months this morning.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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