The week-end decision by the US government to put two of the country’s biggest mortgage refinance companies into “conservatorship”, effectively nationalising them, sends out two very strong signals to markets and policy-makers. The decision itself was precipitated by the fact that the persistent slump in the housing market in the US was devaluing the mortgage-backed securities, through which these institutions raised funds from the market. The rising costs of funds accompanied by declining values of their assets would have inevitably led to disaster. With a combined $6 trillion worth of assets on their books, much of it held overseas and therefore risking global faith in the US government (the mortgage companies are widely perceived to have an implicit government guarantee), the mortgage companies were clearly “too big to fail”. That they certainly are, but this constitutes the largest financial nationalisation in world history, and effectively doubles the US government’s public debt. The proponents of the move apparently believe that the slump in the housing market is far from over and, in the absence of interventions such as these, a whirlpool-like force would simply drag down the entire financial sector. By effectively guaranteeing the liabilities of these institutions, the government is making it easier for them to raise money, bringing down their cost of funds and, eventually, lowering the rates at which home loans are made. Assuming that things work out as planned, this will contribute to steadying the housing market, and thereby tackle a major reason for the anticipated recession in the economy.
The financial markets will read two, potentially contradictory, messages into this action. One, things are actually far worse than they seem, and any recovery is a long way off. This could impact asset prices more widely and reinforce the downward spiral. On the other hand, the government’s willingness to step in and deal with the crisis may provide some assurance that things will not be allowed to go completely out of control. This, in turn, may help to stimulate a turnaround. While the coming days and weeks will unravel what the precise impact will be, there is a much stronger signal being sent with reference to the limits on a government’s role in dealing with a financial crisis. If the US government were to practise what it and, by extension, the multilateral institutions over which it has significant influence, preach, such a measure would have been completely off the table.
The Washington line that bail-outs of errant financial institutions, even large ones, do more harm than good, which has been transmitted from Washington for so many years, rings hollow in the wake of the rescue of, first, Bear Stearns and now Fannie Mae and Freddie Mac in the US, not to forget Northern Rock in the UK, that other bastion of unfettered financial markets. The argument that the systemic risk of massive institutional failure is a legitimate reason for state intervention may not be very visible in the policy rhetoric of these countries and the institutions that they patronise, but is increasingly prominent in their policy actions. This seriously undermines the message that is being sent out to other countries, particularly those with evolving financial systems, that private interests should play a dominant role in that process. If the US, amongst the most mature and efficiently regulated systems in the world, will not shy away from government takeovers of bankrupt institutions to avert a crisis, why is this not a legitimate action by other governments as well? Whatever the immediate compulsions may have been, this action will certainly change the nature of the debate on financial regulation and rescue packages.