Thursday, July 10, 2008

Will Fannie and Freddie Cause More Credit Market Turmoil?

With the credit market recovery predicated on the precarious balance derived from Federal Reserve liquidity injections, capital infusions by sovereign wealth funds and investment managers, and bailouts of major financial institutions, one must wonder if this period of stability has legs. Prior fits of turbulence in late summer 2007 and March 2008 led to dramatic market seizures that froze access to capital, eroded confidence in counterparties, and led to the demise of two dominant financial institutions. The current credit market predicament is the result of years of overabundant liquidity and exorbitant hubris among Wall Street bankers that led to an inexplicable decoupling of risk and return. Begrudgingly, market participants are revaluing deflated assets as the extent of credit impairment in the financial system continues to be exposed.

The erosion of capital at both large and small financial institutions has resulted in unprecedented campaigns to recapitalize through both equity and debt issues. Thus far, liquidity has continued to be available, especially for those institutions deemed “to big to fail”. A failure of any of the largest financial firms, it is suggested, would erode public confidence and permeate through the financial system such that regulators would be compelled to step in and prevent the inevitable collapse. Once the Federal Reserve stepped in to coordinate a bailout of Bear Stearns, precedence was established giving credence to the theory of “too big to fail” and providing a false sense of security that decouples risk from return. Investors of all stripes have devoured new debt and equity issues of large banks and financial firms under a false sense of security. Ultimately, investors will once again realize that no firm is immune from failure and there is much more risk in the system than originally perceived.

The government, seeking to prevent future failures, has attempted to pass legislation to bailout the mortgage lenders, transfer risk to the Federal Housing Administration, and facilitate jumbo lending through Fannie Mae and Freddie Mac. By encouraging the refinancing of mortgages through the FHA, Congress will effectively transfer future housing losses to taxpayers while enabling financial institutions to offload their highest risk loans. Given that previous attempts to stimulate the mortgage market by expanding the lending limits of Fannie and Freddie have failed and the securitization market has collapsed, the only source of incremental mortgage liquidity is through government guaranteed FHA loans. Soon, however, the limited liquidity provided by Freddie and Fannie in the conforming loan market may dry up as well. Mounting credit losses confront incredibly low capital levels, raising the risk of default and dictating a Herculean campaign to raise at least $75 billion in capital. Major commercial and investment banks, however, have raised more than $100 billion over the past year jeopardizing the GSEs’ ability to amass the requisite amount of new capital.

A further contraction in mortgage market liquidity could push the credit and housing market to the brink of collapse. Just as an abundance of easy money drove the housing bubble to inexplicable heights, a lack of liquidity has restricted access to credit and reduced turnover in the housing market. Without additional capital, Fannie and Freddie will be forced to constrain their balance sheet, limiting their ability to issue new mortgage loans. This will lead to a dramatic increase in mortgage credit losses, a slowdown in economic growth and employment, and further write-downs which raise the probability of bank failures. With the Federal Reserve’s policy responses limited by the bailout of Bear Stearns and its Term Auction Facility (TAF) commitments, the government, and ultimately the taxpayer, will be forced to bailout the financial system in order to avert disaster. The ability of Fannie Mae and Freddie Mac to raise capital over the next few months may determine the future of the credit and housing markets and dictate the severity of the economic downturn.