Is credit catharsis really coming up?

Financial commentators seemed in late August to be looking for catharsis from the imminent collapse of a few more big American financial institutions. The implicit idea seemed to be that if we could just take a little more pain, everything would go back to normal. Right or wrong?

On the current shortlist for being wiped out are Fannie Mae and Freddie Mac, the so-called government-sponsored entities that hold or guarantee about half of US mortgage debt, and Lehman, the investment bank that majored in mortgage-backed paper.

At bottom there is no mystery. These outfits owe more than their mortgage assets are probably worth these days. They got away with way too thin of an equity cushion to support the debt and debt-related derivatives they took on, so it did not take much of a drop in the value of housing that underlies their assets to send them under. It should be no big surprise that Korean and Chinese investment funds decided not to rescue Lehman. Nor that foreign money is shying away from funding Fannie and Freddie bond offerings until it sees how the Treasury really plans to stand behind the mortgage giants.

But if the stockholders of these corporations do get wiped out, how does it leave the economy? If Lehman disappeared would anyone much notice, as long as its demise were managed like Bear's, so there is no chain reaction of global banking crises? The securitisation of mortgages was Lehman's specialty. The traditional mortgage-banking approach, where originators stay on the hook, seems to have fewer perverse incentives. Even a complete end to mortgage securitisation should cause few tears. Indeed, for those who follow Harvard's Ken Rogoff, formerly a senior official at the International Monetary Fund, reducing banking capacity is desirable. Presumably getting rid of the worst risk-takers qualifies as reducing capacity.

In the case of Fannie and Freddie, though, the Treasury seems to have little choice. Taxpayers will end up taking responsibility for the huge borrowings of those behemoths. The betting seems to be that the Treasury will effectively take over the entities and also become the borrower of fresh money to back new mortgage issuance.

With the Treasury propping up the mortgage market more directly than before, the key will be whether foreigners continue to buy Treasury debt at the same low rates as they have been historically willing to do. If they do, then this continued recycling of foreign surpluses back into the pockets of American borrowers could keep the credit game going for a long while. That is not all bad. It could allow for a gradual decline from outsized US savings and trade deficits, which correspond to massive Chinese and petro-state savings and trade surpluses. The alternative would likely be a cataclysmic adjustment – perhaps with a foreign lending squeeze, Treasury rates going sky high to attract lenders, and a consequent deep downturn in gross domestic product. That appears to be in nobody's best economic interest.

The trend in housing values, that is seen as central to the wealth effect on the US and global economy, will be affected by the rate on a new 30-year mortgage. If new mortgages become cheaper than the current 6.5 per cent, that will boost demand for homes. That rate is governed by the price of new borrowing by Fannie and Freddie or their successor banks. Lately, foreign reluctance to put more money into Fannie's kitty has kept mortgages fairly expensive, which has exacerbated the decline in housing value, causing a vicious circle. With the full support of the Treasury behind some sort of reconstituted Fannie and Freddie, it should be possible to engineer lower rates. A virtuous circle might be the outcome.

The tricky issue will be how to limit the amount of new mortgage credit the Treasury will create. If Koreans and Chinese and petro-giants will lend limitlessly to the US taxpayer, where is the constraint on mortgage creation?

Other adjustments in the housing market are working their way along. Housing starts keep dropping, because fewer and fewer builders and bankers can see any joy in owning vacant homes. This decline in new supply eventually helps to bring supply and demand into balance.

Also helping, to some degree, will be the gathering efforts to stem the foreclosure wave. Keeping folks in their homes prevents a worsening of the glut of houses. July's housing finance legislation was set to help a little. Now, the Federal Deposit Insurance Corporation (FDIC) has a chance to show bankers that it is in their interest to do more loan renegotiating and less foreclosing. The FDIC is the lucky outfit left holding the bag when commercial banks go broke. They have to pay off depositors, up to $100,000 (Dh367,334) apiece. To avoid depleting their funds, they must recover as much from the loans on the defunct bank's books as they possibly can. Sheila Bair, the head of the FDIC, has been vociferous in her belief that foreclosure is self-defeating. Now she has a big portfolio of mortgages, from the bankruptcy of IndyMac Bank, and plans to vigorously test the idea of cutting loan principal to the current value of the home to help keep borrowers in their houses and making loan payments.

Prices in some of the local markets that saw the most extreme run-ups have fallen back to the point where, on some measures, they are close to being in line with incomes. In other words, young families should begin to find them affordable again. Now they just need to be convinced that they are not buying a pig in a poke. There will probably be a sudden rush when buyers all guess together that prices have stopped dropping. The trigger for that may be if and when those 30-year mortgage rates fall to 6 per cent.

The idea that the Treasury can probably engineer that interest rate all by itself is a bit scary. The Federal Reserve has never been able to control mortgage rates directly, which theoretically left a role for global credit market players to act as some kind of check and balance. Will the Treasury, which ultimately means the White House, end up in the game of targeting how much the voter's house price rises? This could be interesting. Yet nobody in the wake of this decade's bubble can argue that the Federal Reserve or the free market did a competent job on house prices and supply. If it is a choice of Countrywide and Lehman or the Treasury, most would now give the latter a chance at bat.

Eventually, it would be valuable for the world's creditors to have an organised voice on US debt expansion. Just staying away from Fannie Mae debt auctions occasionally does not provide adequate discipline, though it is a start. Smaller economies, from Britain to Argentina, have had to listen to the International Monetary fund in the past. That has sometimes been constructive in obliging governments to spend within the country's means.

As the US Treasury takes on Fannie and Freddie's obligations to become the housing lender of last resort, and possibly of first and only resort for a time, the government deficit will only widen. Add to that the $29 billion Bear Stearns bailout by the Fed. Perhaps pile on at least one other financial system rescue, since Lehman will doubtless be deemed too enmeshed with the rest of global finance to fail. It is not that the Fed and Treasury have much choice about these moves. However, something has to force politicians to gradually cut spending and raise taxes, or the national debt will balloon to the point that it provokes a crisis of global confidence. It should not be left to comedian Steven Colbert to declare shock at our recent bout of inflation: "Who said there had to be consequences for America fighting two wars for a trillion dollars without raising taxes?"