Our old friends Fannie and Freddie are back after a summer holidays neither could have enjoyed, having spent it largely in the financial doctor's surgery, otherwise known as the office of Ben Bernanke at the Federal Reserve. Both Fan and Fred are still in critical condition, and their ill-health could yet further infect the rest of the US economy.
They have had their ups and downs, at times appearing on the brink of recovery after having taken a big dose of Bernanke's medicine. Take for example two headlines from the Financial Times, separated only by days. "Fred and Fan crisis eases" said the FT on August 21, only to follow that four days later with "Fred and Fan crisis spreads." If the omniscient FT cannot call it right, how are the rest of us mere mortals supposed to know what is going on?
A little bit of context is required. Freddie Mac and Fannie Mae are the names of the two organisations which effectively control the financing of the American housing market. Created by Federal statute last century, they are intended to demonstrate the government's commitment to house finance stability by organising and operating the market in mortgage-backed securities – the essential pool of capital that ensures liquidity in the US property market.
Crucially, both Fred and Fan also have shares traded on the New York Stock Exchange. Earlier this year, after months of battering of asset values in American real estate, these shares began to fall sharply as investors began to realise that the value of securities backing Fan and Fred products was much more doubtful than they thought. In a nutshell, the falling US property market – down 16 per cent over the past year – meant many mortgages were not the cast-iron investments marketed by Fred and Fan.
The resulting sell-off in their equity prompted an unprecedented intervention by Bernanke, worried that the knock-on effects would seriously damage the financial and consumer sectors. With Fred and Fan between them speaking for roughly half the US property market, with some $5.3 trillion (Dh19.4trn) of mortgage assets on their books, it is easy to see why the Fed took the issue so seriously.
Bernanke's bail-out held the crisis in check for the month of August, but last week the cracks started to re-appear and widen. Though the Fed had stopped short of outright nationalisation, it reserved the right to wield that very un-American weapon in the last resort, and this had an inevitable effect on Fred and Fan's ordinary equity – shareholders saw little appeal in owning stock that could be compulsorily bought by the government at a knock-down price any minute. The share began to fall again.
More significantly, the preferred shares in Fred and Fan – senior stock apparently safeguarded from the nationalisation threat – also began to look vulnerable. Blue-chip bank JP Morgan said it might have to take big write-downs on its Fred and Fan prefs, as much as $600 million this year. If that were repeated across the financial sector – and virtually every US bank has exposure to Fred and Fan preferred equity – it would again trigger a bout of write-downs. This is the big fear of the US authorities – that the banking and financial sector would be so weakened by property related losses that normal business could not be maintained. The result: a crash of 1929 proportions and the threat of a depression to rival that of the 1930s.
As the latest worries over Fred and Fan resurface, we are still not clear of that danger. Some calm was restored to the market this week when Citigroup – itself badly damaged by the credit crisis – said there was still value to be had in Fred and Fan assets "if the companies pull through the housing crisis". Although intended to reassure, this strikes me as about as convincing as saying the Titanic would be a great ship – as long as it avoid the iceberg.