Fannie and Freddie Bailout Doomed, Lessons from UK Northern Rock Bust

By: Nadeem_Walayat

One of the aims of the take over of the Fannie and Freddie by the US Government is to stabilize the housing market by taking over and providing liquidity to the mortgage market is doomed to fail. In the UK we have the example of the Northern Rock bank bust of Sept 07 and what subsequently transpired over the last 12 months as a possible guide of key assumptions being made now in the US that could prove to be wrong.

The Northern Rock bank failure witnessed a rise in mortgage interest rates as the bank sought to reduce its loan book to cover losses, in doing so it was forcing mortgage holders to remortgage to other banks as their fixed rates became due and the borrowers were stuck onto high variable rates. The more recent capital injection into Northern Rock bank of £3 billion i.e. a swap of loans to the bank for equity illustrates that the bank is sitting on huge losses that will now be borne by the UK tax payer over a series of such capital injections.

a. The net result will be UK tax payers look set to lose at least £10 billion, or 10% of the original mortgage loan book.

b. The net result for mortgage holders is that they were forced to pay higher interest rates as mortgage rates across the market rose, this from the fallout of a bank that controlled nearly 10% of the UK mortgage market. Additionally the bank became more eager to foreclose and hence contracted in size, as it also sought to sell of the saleable parts of its mortgage book to other banks.

Implications for the US Nationalization of Fannie Mae and Freddie Mac

a. US Tax payer losses could reach $500 billion, at the rate of 10% of the Fannie and Freddie's Mortgage book

b. The bailout will NOT help the US housing or mortgage market, as all of the money pumped into the two banks will be consumed by uncovered losses with little or nothing left over for new mortgage borrowings as the true scale of losses is far above the estimated loss of $25 billion.

c. Fannie and Freddie have exposure to 80% of US mortgages, therefore a contraction in the mortgage book will actually lead to far greater distress amongst the US housing market as the market will not be able to cope with remortgaging away from Fannie and Freddie and hence foreclosures look set to soar.

d. The huge loss of $500 billion will devalue the US treasury bond market and hence lead to higher bond yields as Fannie and Freddie bond yields converge with US treasury bonds, perhaps meeting somewhere in the middle, as both debt mountains are put at $ 5 trillion each. This implies it will become harder for the US treasury to perform future bailouts due to the risk of further loss of confidence in the US bond market, which implies deeper credit contraction.

Therefore the bailout will have failed as it will have not achieved its objectives, but rather bought time to allow the mortgage market to contract further, i.e. a slow unfolding crisis rather than a crash event, but the problem is the price paid in the loss of quality of US bonds as perceived by the market place, which will make US government debt refinancing more difficult in the future.

Meanwhile many comments have come my way that under these conditions the US dollar should weaken instead of what has transpired recently, in this regard consider the following two factors:

1. That the US dollar has been in a 7 year bear market and since making its bottom in March this year, it could easily have a corrective bull market rally for as long as a year, therefore this confirms my earlier analysis that the USD is targeting 90 by early 2009 (bottom 70, current 79).

2. That the US authorities are more competent than those elsewhere at handling and coping with the global derivatives deleveraging crisis, i.e. than the UK, Europe, China, Japan, etc. This is my conclusion from my vantage point across the pond, perhaps US analysts are too close to the epicenter to focus on the competency of other governments and their central banks. Though clearly the collective forex market place is recognizing this to be so, hence bidding the dollar higher when the consensus view is that it should be being sold.

For more on the credit crisis read yesterdays article- BANKRUPT Banks Wiped Out by Tulip Backed Securities, Is China Cheap?

By Nadeem Walayat
http://www.marketoracle.co.uk

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Nadeem Walayat has over 20 years experience of trading, analysing and forecasting the financial markets, including one of few who both anticipated and Beat the 1987 Crash. Nadeem is the Editor of The Market Oracle, a FREE Daily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 150 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction. http://www.marketoracle.co.uk

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