Fixing Fannie and Freddie

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After nodding and winking itself into exhaustion, Washington has had to make its support for Fannie Mae and Freddie Mac explicit. The two government-sponsored enterprises are not Bear Stearns. But repeated statements from US officials that the GSEs are adequately capitalised have not worked – hardly surprising when their direct and guaranteed liabilities were almost 65 times their regulatory capital at the end of the first quarter.

Near term, the priority is retaining the confidence of buyers of Fannie’s and Freddie’s debt, many of whom are foreigners. By increasing the GSEs’ credit line and pushing for authority to inject fresh equity if necessary, the Treasury’s plan should allay fears of failure. Freddie seemed to have few problems offloading $3bn of new paper on Monday, although some arm-twisting may have been needed to persuade banks to buy it.

The bigger problem for Washington is that merely stabilising Fannie and Freddie is not enough. With US banks licking their wounds, the GSEs – which own or guarantee 22 per cent of the $24,300bn borrowed by US households and non-financial businesses – are critical providers of new credit. Yet it is difficult to see how they can keep doing this. What is needed, albeit over a period of years, is for their bloated balance sheets to shrink, pushing up their razor-thin capital ratios and reducing the US government’s role in supporting the housing market. In the near term, Fannie and Freddie may require one or more dilutive capital injections from the Treasury, which is why Monday’s initial rally in the GSEs’ stock was so bizarre.

Despite these ad hoc measures, there is no escaping the fact that credit capacity is disappearing in the US. Foreign capital may help, but every new crisis makes the US a less attractive bet. Pressure on US banks to merge and recapitalise further, in order to give them enough confidence to pick up the slack, will increase. None of this can happen quickly. In the meantime, housing markets will suffocate for lack of the oxygen that is credit and financial assets will continue to sag for want of any real appetite for risk.

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