Credit Crunch Fears Escalate as Key U.S. Mortgage Financiers Struggle

Desperate Times

The disastrous U.S. housing slump has claimed plenty of victims along the way, from individual home-owners to construction firms, estate agents, and lately to some of the country's largest financial institutions. With all financial players feeling the pinch and avoiding risk wherever possible, it is harder than ever for those struggling to raise sufficient funds to keep their heads above water. Rumours are constantly flying about who might fall next, and if negative sentiment takes hold it becomes self-reinforcing. All eyes this week are on the government-backed mortgage giants Fannie Mae and Freddie Mac. There have long been concerns about how they will cope with the housing crisis—and indeed about how they have been managed—but their situation has dramatically worsened this week. Yesterday alone Freddie shares dropped 22% to just US$8, while Fannie fell 14% to US$13.20. Together, their stocks have lost over 80% since a year ago. They are traditionally seen as safe bets given their huge financial muscle and government backing, but investors are no longer so sure. Their plight is also turning the spotlight on the many banks who have lent them huge sums. The latter have been posting massive losses in recent quarters, and could now suffer another body blow.

The two institutions' problems stem from the collapse of the value of home loans they hold and rising obligations in meeting debt guarantees. They need to raise capital to make up for this, but such capital can be hard to find even for them. It is hard to understate how important they are to the U.S. housing market. Between them, they own or guarantee around US$5.2-trillion-worth of mortgages. Most of these are "prime", rather than the sub-prime loans that helped trigger the housing slump in the first place. Treasury Secretary Henry Paulson told Congress yesterday that "They touch 70% of the mortgages that are made in this country. They are a very important part of our economy, a very important part of our housing market." At the same hearing Federal Reserve Chairman Ben Bernanke said that they "are playing a critical role" in the mortgage market, but called for regulatory reforms. The two men have been leading efforts to ride out the financial and housing markets' firestorm over recent months, and with a fair degree of success. The two firms were originally created by Congress to ensure greater availability of home mortgage funds. They are able to do so thanks to their access to comparatively cheap capital. It is so cheap because of the perception that the government guarantees their debt. The latter is not strictly true, but this has always been the assumption. Paulson, Bernanke, and the firms' heads were at pains yesterday to stress that the two firms are still accessing sufficient capital without difficulty.

So what are the scenarios?

• The best-case scenario is that they ride out the latest wobble and that government reassurances will turn out to be well founded. Their search for fresh private capital would prove fruitful. The housing market could finally start to climb out of its pit in coming months and suddenly their financial health will look a whole lot stronger.
• A middle scenario is that they will need to turn to the government for some form of help. They are surely "too big to fail", so the government will respond. Under existing law, they would fall under the control of their government regulator if they become severely low on capital. Government help might be costly and risky but, under this scenario, would restore stability. There are various different ways the government could step in—one of the more likely is for the Federal Reserve to buy up some of their debts and make long-term loans on generous terms.
• The worst-case scenario is that the firms are in dire straits, that the government assistance proves inadequate, and that they effectively go into default and cannot honour their loan guarantees. The government would presumably be forced to take them over and leave their shareholders with little or nothing. Taxpayers would have to meet their most unavoidable obligations. This scenario would be more likely if the housing market continued to decline, pushing more and more homeowners into default. If the two firms are unable to meet their obligations it means a real calamity for the financial system, given how closely entwined numerous other financial institutions are with them. It goes without saying that the economy would suffer greatly too. If they were unable to perform their usual housing market stimulus role, the latter's recovery would be that much slower.

Meanwhile, Lehman Brothers is Pummelled

The panic surrounding Freddie Mac and Fannie Mae is meanwhile exacerbating the rumour mill surrounding Lehman Brothers. The bank's shares shed another 12% yesterday, falling to US$17.30. Its shares have now lost 70% of their value this year. There are concerns that it is following in Bear Stearns' footsteps and could need an emergency bail-out. In Bear Stearns' case, JPMorgan Chase sprang into action and picked up its near-bankrupt rival for a song. This would not necessarily happen for Lehman Brothers, and the government has been warning in recent days that it will not automatically bail out failing banks. Lehman Brothers argues that rumour-mongers are overstating its problems and that it is not struggling to raise capital. The bank is more exposed than some of its competitors because of its heavy involvement in the mortgage market, its assets in which have plunged. It does have access to the emergency loan programme introduced by the Federal Reserve in March, which gives it some more breathing space. This is due to expire in September, but now it seems it will be extended into next year.

Outlook and Implications