Credit Crunch Doesn’t End with Fannie & Freddie Takeover

News that the US government is effectively taking control of Fannie Mae and Freddie Mac and becoming the nation’s biggest mortgage guarantor was greeted with cheer by financial markets desperately hoping that it marks the beginning of the end of the credit crunch. Sadly, they could be disappointed.

Investors who are cheering the “temporary nationalization” are Fannie and Freddie bond holders, as the implicit government guarantee has now become explicit.

Central banks, sovereign wealth funds and financial institutions across the globe invested in Fannie & Freddie bonds as a higher yielding substitute to normal Treasuries.

Had the two government mandated institutions been allowed to go bust, it would have created diplomatic tensions with the likes of Gulf investors, savaged the dollar, sent global equities into freefall, significantly worsened the credit crunch and would have seen the US housing market accelerate its downward spiral. So in the short-term, effective nationalization is a good thing. And foreigners, read Chinese and Gulf investors, will keep lending to the US. The time frame is also important given that there is a Presidential election just two months away.

Further out the macro picture becomes a little more complicated. For one it socialises the errors of bankers i.e. the tax payer bails out their mistakes – the so called moral hazard mentioned by Mervin King, the governor of the Bank of England when UK mortgage lender, Northern Rock was nationalised because its funding model was so dependent on now seized up credit markets. When the next round of market reforms comes about, regulators need to make bankers more accountable for their actions and make it more difficult to engage in reckless lending behaviour, whether they be private institutions or government mandated ones. The way bankers are incentivised also needs rethinking and the driver for that will have to come from governments.

Secondly, critics such as well-known investor Jim Rogers and an advocate for allowing these institutions to go broke, say such bail-outs are inflationary in the long-run and will eventually undermine the dollar. Both points are correct, but allowing Freddie and Fannie to go bust would have dire economic consequences that no democratically elected government would willingly tolerate. Both government and the electorate would rather suffer high inflation than an economic depression.

Nonetheless, the bail-out is unlikely to mark the beginning of the end of the credit crunch. According to a BBC report roughly 9% of US homeowners are in mortgage arrears and real estate prices continue to fall. Meanwhile, unemployment is rising and the economy may soon slip back towards recession. That suggests that there are a lot more repossessions (foreclosures) to come and real estate prices are likely to sink further.

State-ownership of the mortgage guarantee market will also bring the government into direct conflict with defaulting mortgage holders who also happen to be voters. Could that influence government decisions regarding repossessions? And in turn slow the clear-up of the mortgage mess?

Within a few weeks from now, the markets are likely to realise that the credit crunch is far from over and that recession is in fact digging its way deeper into the world economy, just as it was last week.

That also means that there is unlikely to be a dramatic pick-up in M&A activity anytime soon, especially for mega-deals.

The nationalisation may help make the credit crunch shorter, but it hasn’t solved it. Besides, it creates a whole set of new issues in terms of government debt and the fact that it may now increase massively. Could that spook fixed income investors? Higher yields on government bonds will make borrowing more expensive and potentially depress stocks.

The takeover may in fact create new “hazards” such as institutionalising the socialisation of lenders’ and borrowers’ mistakes. This must not be allowed to happen the next time around. After the bail-outs must come sounder regulation for the sake of the long-term health of the global economy.

This post first appeared at Thomson Merger News