With the price of a barrel of oil exceeding $146 and stock markets reeling, the global economic turmoil has worsened this week. Yet most remarkable of all has been the sight of socialist turkeys coming home to roost in the US, home of free-market capitalism. These sorry birds, colloquially known as Fannie Mae and Freddie Mac, are “government-sponsored enterprises”. What exactly that means we may soon discover.
With combined liabilities of $5,300bn, about 38 per cent of US gross domestic product, these massive fowls are universally deemed too big to fail. Since they account for nearly three-quarters of new mortgages, they are too important to do so. If they ceased to lend, the housing market might collapse, so devastating US financial stability.
Yet if the federal government had to place the debt of the two entities on its books, the gross financial liabilities of the US government would exceed 100 per cent of GDP. Fortunately, things are not as bad as that, since the assets of the two lenders will continue to have value.
The real problem, demonstrated in the tumbling prices of their equity, is that their capital is insufficient to support their liabilities, given the scale of possible losses. William Poole, former chairman of the Federal Reserve of St Louis, argued only this week that Freddie Mac would be insolvent if the value of its assets were marked to market.
On the assumption that maintaining the ability of the two giants to lend is essential, there are just two ways out: for the two lenders to raise large amounts of additional capital or for the government to guarantee their liabilities explicitly.
In his congressional testimony this week, Ben Bernanke, chairman of the Federal Reserve, encouraged Fannie and Freddie to raise capital. This would certainly be expensive for existing shareholders and risky for new ones. The government might itself invest in such a capital-raising operation. Alternatively, the government might take one or both over, presumably after wiping out existing shareholders. This would apparently be called a “conservatorship”. On the other side of the Atlantic, it would be called “nationalisation”. It would make the UK’s nationalisation of Northern Rock look like a mere bagatelle.
The woes of Fannie and Freddie are important in themselves. But they are far more important for what they tell us about the ongoing crisis: it is still spreading. US house prices continue to fall, likely losses in the overall financial system continue to rise, credit continues to be tight, the US economy continues to be weak, household consumption is under growing pressure and oil prices are going still higher.
Meanwhile, the US Treasury and central bank are improvising desperately. The equity markets have, at last, noticed how difficult things are. Only the most optimistic would believe that the worst will soon be over. The crisis worsens, instead.
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