Many on Wall Street had begun to call the end of the credit crisis earlier this year. To be sure, things were still looking grim on stock markets, but that was more a product of high oil prices and persisting fears of a recession hurting profits. The toxicity associated with sub-prime mortgages had appeared, to some at least, to be clearing up. The banking sector, while still facing some bad news, looked like it could breathe just a little bit easier. Yet such forecasts now look to have been premature. Like a zombie, it seems, the credit crunch is refusing to die.
The troubles that have inflicted two government sponsored mortgage giants in the US, Fannie Mae and Freddie Mac, have once again spooked investors. Meanwhile another lender, California’s IndyMac Bank, has been taken over by regulators amid concerns over its liquidity. A run on the bank by some customers had not helped matters much. Yet it is rightly Fannie and Freddie where most attention is focussed. These two leaders in the secondary mortgage markets owed or guaranteed $5.2 trillion between them. As speculation mounted that Fannie and Freddie would be unable to meet their obligations, the alarm bells ringing on Wall Street came to be heard in Washington DC. To avert a catastrophic collapse of either or both of the agencies, Treasury Secretary Hank Paulson announced a new rescue plan, exposing taxpayers to potentially billions in liabilities.
Action was necessary, that much is clear. While moral hazard issues are always important to consider, the reality is that some banks are too big to be allowed to fail. Proving a point is recklessly counter-productive if it devastates the economy in the process. This was clearly the case with Fannie and Freddie, which own or guarantee almost half of all American mortgages. Yet, as The Economist rightly notes this week, there are right ways and wrong ways to go about things. With this new bailout, Washington has got it wrong. Though it might seem unpalatable, Fannie and Freddie should have been nationalised, reformed, and sold off.
It is important to remember that Fannie and Freddie, while private institutions, were set up at the behest of Congress. Fannie Mae — or its formal title, the Federal National Mortgage Association (FNMA) — was set up in 1938 as part of President Roosevelt’s New Deal package to restore liquidity to the mortgage market. Then, in 1968, Congress privatised Fannie and set up Freddie Mac — the Federal Home Loan Mortgage Corporation (FHLMC) — as a competitor. The raison d’être for these institutions was to provide liquidity to mortgage markets. Instead, they have contributed to the problem. Rather than providing specialised services, Fannie and Freddie came to rely on the sorts of commercially viable standard home loans that they were never supposed to be involved in. Washington has done nothing.
A large part of the problem is that Fannie and Freddie have become powerful lobby groups in their own right. Consequently, politicians and regulators have been loath to do anything to curtail the institutions’ operations. This also explains why there has been surprisingly little talk about breaking up Fannie and Freddie — executives from the two groups have donated millions of dollars to political campaigns over the past decade. Such political patronage should hardly inspire confidence among investors or within the broader community. In an economic crisis, tough decisions need to be made — in this case, fundamental reform of two institutions that have proven they no longer have a place. Instead, Washington is allowing the the zombies of the credit crunch to continue to roam. Scary times still lie ahead.