Opinion: What the US mortgage bailout might mean for us
8th Sep 08, 10:26am
The US Government has announced it will take control of US mortgage behemoths Fannie Mae and Freddie Mac to prevent their collapse completely cripping the US housing market, and therefore damaging the world's largest economy. The scale of this move is enormous and will have global ramifications. Fannie and Freddie are the guarantors of almost half of the US$12 trillion of US mortgages in existence right now. The progressive collapse of confidence in the US sub-prime mortgage market since mid 2007 has seen funding for everyone else but Fannie and Freddie dry up. The US government guarantees they have for their debt (recently made explicit) have meant the two federally mandated but privately owned firms have been writing more than 70% of US mortgages. Their collapses would have been a catastrophe for the US housing market and for the US financial system. That's because many US investors and US banks own bonds guaranteed by Fannie and Freddie. Many overseas central banks and commercial also hold trillions of dollars of these bonds. The system would have ground to a halt. As it is, many of these same investors and banks will feel the pain of seeing the value wiped out of any shares they hold and potentially any preferred shares they hold. The US Treasury will immediately take a 79.9% stake in Freddie and Fannie and potentially pump US$200 billion of capital into their balance sheets. The US government has also extended a secured credit facility to 12 other Federal Home Loan Banks. So what does this mean for us? The sheer scale of the rescue and the sense of shock that the US government was forced to bail out the mortgage market will reverberate around finanicial markets. Already the New Zealand dollar has jumped to 68 US cents by mid Monday morning from as low as 66.2 US cents on Friday night. The giant mortgage bailout damages the prestige of the US dollar and implies a massive amount of fresh US government credit will be pumped into the US financial system. That, in theory, would prove inflationary and therefore reduce the value of the US dollar. But there could be other ramifications, particularly for global interest rates. This could either calm things down and reassure investors that the worst is over. Or it could shock foreign investors into realising we are in the middle of a once in a lifetime deleveraging event that will spread throughout the global financial system. That will make foreign investors even more wary of lending to "riskier" economies (than their own) such as New Zealand and Australia. New Zealand banks owed foreign lenders NZ$135 billion at the end of March, including NZ$61 billion that has to be refinanced every 90 days. More market volatility is likely to increase the interest rates those foreign investors will charge us to keep borrowing that money. The chart above, which measures the difference between interbank lending rates and pure wholesale rates, is a proxy for the increase in funding costs for New Zealand banks. Our banks have had to absorb a 70-80 basis point increase in funding costs in the last year. Some of it has been passed on, but the rest hasn't, reducing their profit margins. This increases the funding costs for New Zealand banks, which would mean they would be reluctant to pass on any cut by the Reserve Bank in the Official Cash Rate (OCR) on Thursday. Banks passed on the July 24 rate cut to fixed mortgage rate customers but didn't cut it for variable rate mortgage customers. The bailout of Fannie Mae and Freddie Mac increases the risk that this week's OCR will not be passed on in full to all borrowers here. The worst case is a complete freeze of the global financial markets. If that happens, would force our banks to ration credit. New mortgage lending in New Zealand crashed to just NZ$201 million in July from over NZ$1.5 billion a year ago. Some of that is demand releated as the property market slumps and home owners don't want new mortgages. Some will be related to consumer spending related as homeowners stop using their houses like ATMs. But the rest is the banks clamping down on 'easy' 100%-plus loans and 'low doc' loans to property investors and others. Anecdotally, we regularly hear that the 'easy' deals offered by banks with high loan to value ratios and high loan to income multiples have disappeared in recent months. All of this activity is symptomatic of a 'deleveraging' of housing debt globally. Banks stop writing new loans, which means house prices fall, which means home owners go into negative equity, which means they hand their houses over to the banks, who sell the houses to recover their money, which forces down the prices and so on. This article here explains this 'deleveraging' and the debt death spiral better. The US government is trying to stop this debt death spiral in the market where it's happening first and most severely. It's happening elsewhere too. British house prices are tumbling because banks have stopped lending. It is happening to a lesser extent here because our banks have not been as exposed to calamitous US sub-prime lending. The real risk comes for our banks when foreign banks and investors reduce their lending to our banks to fund that NZ$135 billion of foreign debt, which is really our household debt. A wholesale reposession of New Zealand Inc is highly unlikely. That would require banks to force homeowners to sell up to repay their loans before the term has expired. It is more likely a bank would get into trouble before that happened. But all this volatility and the once in a lifetime deleveraging of housing debt globally will mean higher interest rates than would otherwise be the case and the potential for credit rationing. This will keep downward pressure on our house prices and keep our economy in the doledrums. Buckle up. We're in for a rough ride.