Who would ever have thought that Freddie Mac and Fannie Mae would hold the fate of the financial markets in their hands? Until last week, the two American mortgage companies were certainly big – with some $6 trillion (Dh22trn) of assets between them they control half of the property market in the world's biggest economy – but they were not exactly exciting or historic, in the sense that the actions of the self-styled "masters of the universe" of the investment banking world are exciting, and potentially historic.
Born out of two different US government rescues from previous financial crises, in the 1930s and 1970s, they were lumbering financial giants apparently (and that appearance was important) backed by the US Government.
Not any more. Today, as the market delivers its verdict on the Freddie and Fannie rescue plan drawn up over the weekend by the US Federal Reserve and the Treasury Department, the two find themselves at the crucial tipping point of what could turn into the Great Crash of 2008. Some, as Franklin D Roosevelt noticed, have greatness thrust upon them.
I met Freddie Mac executives earlier this year in Dubai, when they were on a road-show to drum up investment in their mortgage-backed securities products from the Gulf, and nicer people you could not hope to encounter. They explained their business to me with great clarity, talked me through the scenario – as they saw in from a late spring viewpoint – of how the credit crisis was affecting them, and left me with a warm feeling that, while the world was not at the end of the great credit crisis, we were perhaps at the end of the beginning.
There was light at the end of the tunnel, Freddie explained, because they were not sup-prime victims – the property that backed their assets was not held by Mid-West trailer-trash in the "ninja" (no income, no job) category. With the implicit backing of the US Government, they actually saw great opportunities in the coming months to purchase solid assets from distressed sellers in some of the USA's hottest property spots – California, Florida, New England.
And, significantly for Gulf investors, they had been successful in persuading Middle East investors to listen to their story and believe in it. Some $1 billion of new investment had flowed from the Gulf in the first quarter, it was suggested, as regional financial institutions swallowed Freddie's line that there was value to be had in US property-backed securities. (That is one substantial reason UAE investors should have a keen interest in the outcome of the Freddie and Fannie rescue pieced together in New York and Washington.)
I do not for one moment believe the nice people from Freddie were trying to mislead me or Gulf investors with their optimistic view of the world. But it is obvious the events of last week have proved them wrong. Perhaps they were conscious of their responsibility not to exacerbate an already difficult situation. The charitable view is that they – like the rest of the world – had underestimated the extent of the collapse in US asset values which, even then, was proceeding headlong downwards.
The events of last week showed just how badly we all got it wrong. Part of the reason for their difficulties lies in the hybrid nature of the two companies (government sponsored enterprises but with full stock exchange status), which left them exposed to the harsh winds of the equities markets. We have yet to hear definitively what caused the run on their shares, but by Friday Freddie had suffered a 50 per cent, and Fannie a 30 per cent, fall in their NYSE-listed shares. For such organisations, these are cataclysmic declines, reminiscent of the worst days of trading in the worst ever year for world stock exchanges -1929.
I have written before how the events of that year, recorded by the great economist JK Galbraith, should serve as a sombre warning to us all, especially in the current dire condition for world markets. Crashes do not happen in a day, but are rather the result of a slow drip of day-on-day or week-on-week declines, punctuated every now and again by a vertiginous plunge in values that changes the rules permanently.
That is what happened with Freddie and Fannie last week – somebody, somewhere took the view that their asset backing was not as solid as they claimed, and hammered the shares, setting off a chain reaction of selling that was almost impossible to control. The closure of the US markets for weekend trading came just in time, and gave the authorities a window of opportunity to try to salvage something from the wreckage.
There was more at stake than the fate of Freddie and Fannie, though if they had gone bust – a scenario being more seriously discussed as the week wore on and which actually happened to another mortgage group, IndyMac – that would have been dire. The consequences for the US bond market and the US dollar would have been potentially disastrous, perhaps triggering the much-speculated "geofinancial crisis" in which China dumps its dollar and US bond holdings, the domesday scenario in which America effectively goes bust.
There was talk of "nationalisation" – so redolent of socialist and communist regimes as to be unthinkable to most in the land of the free market – but this would present its own problems. To take over all their assets, the US authorities would have to double the Federal debt, which by itself could trigger the same geofinancial crisis.
The measures announced by US Treasury Secretary fell short of full nationalisation (though that option remains open), but the package is nonetheless so radical that it amounts to a last-ditch solution by the American financial establishment. By seeking US Congressional approval for unlimited authority to lend money to Freddie and Fannie, and give them access to emergency Fed funds while Congress contemplates its reaction, the Treasury has circled the wagons and signalled its determination that the US mortgage market will be the final – and they hope decisive – battle to head off the looming prospect of the Great Crash of 2008.
There are enormous risks. Both Freddie and Fannie are massively under-capitalised (poor Freddie had a debt-to-equity ratio of 1,000 to 1 in March, with $1.9trn of loans and guarantees supported by a mere $2bn of shareholder equity). If they both go to the Fed at the same time for big handouts, it is doubtful even the mighty Federal Reserve has enough cash to keep them going, at least not without enormous damage to the dollar and the US bond market, which would push the US back into geofinancial crisis territory again.
And if the US Government bails out Freddie and Fannie at such enormous cost, will it have sufficient resources to fight the next and (it seems) inevitable battle against Crash 2008? If one or more big US commercial bank were to fail with the government unable to help through lack of funds, it could be just as fatal as the Freddie and Fannie disaster.
The US financial system resembles a ship that has sprung a hundred leaks, each one of which is capable of sinking the vessel. The regulators are scrambling around desperately trying to plug the holes, but are in danger of being overwhelmed. As we wait for the verdict of the equities and currencies markets this week, it is difficult to avoid the conclusion that the troubles of Freddie and Fannie could be the two decisive holes below the waterline.