Fannie, Freddie and Northern Rock – who was right?

The US authorities once again made the right decision to bail out Fannie and Freddie, their two crucial mortgage companies. They did need to offer more liquidity to prevent a further credit contraction and loss of confidence. In offering to put more money in by buying shares they also reassured investors that capital was available. If they have to do so they will reduce the proportion of the companies owned by existing shareholders, who will therefore be worse off when the markets and shares recover. Such an operation would make existing shareholders pay if the companies do need that extra equity, limiting the so called moral hazard of the bail out.

It is another contrast between the bodged, late and far more expensive bail out of Northern Rock conducted here, with the speedy and more effective reply of the US authorities. The purpose of this bail out is very simply to keep some new mortgage finance flowing to a hard pressed and illiquid housing market. In the UK the much dearer rescue of the Rock has led to a further substantial contraction in mortgage finance as the government runs down the mortgage portfolio of its own bank! The US housing market is already in very bad shape thanks to the general reduction in new credit, as US banks rein back in response to the squeeze following past excesses. The US authorities understand this and have come up with a package which makes more money available for people to buy homes.

The UK new housing market is also now shot to pieces by the squeeze, also following past excesses. So what do the UK authorities do? They spend far too much taxpayers money – and put too much at risk – by nationalising the most aggressive mortgage lender in the market, and then have to prevent it lending, achieving the opposite of what is needed. For this they are praised to the skies by Vince Cable and the Lib Dems. The power of their spin is such that usually sensible commentators think they “had to do it”. All other better options, put forward before the event, are ignored.

When the US economy recovers before the UK I do hope all the gulled will revisit this question of whether the Northern Rock model or the Fanny and Freddie/Bear Stearns model worked better when rescuing distressed institutions. I hope some will come to see that the Rock disaster combined all the worst features of regulatory mismanagement and government bungling – the inability to see the disaster coming, a failure to regulate excess credit beforehand, the wrong strategy before the run began when the authorities switched from too easy to too tough, the U turn on moral hazard and the offer of bail out, the dithering over a private sector solution, and then the final idiocy of nationalisation, business reduction and sackings.

The main result of the mismanagement of the UK mortgage market – where the handling of Northern Rock was the most important manifestation of a general incompetence – is the destruction of the new housebuilding industry. The run of lay offs, the cessation of work on many sites, and the plunging figures for new starts can be directly traced back to the way the authorities presided over boom to bust credit in the mortgage market. This was a problem made in Britain, not in the USA where they had their own version. The UK problems are more poignant for a government that was so out of touch it was urging the new homes industry to increase its build rate, unable to understand its own actions meant the build rate would halve or worse!

Some have blogged in to past pieces on my site urging some expansion of mortgage credit on both sides of the Atlantic to argue that the correction is what is needed, the losses serve the bankers and property people right, and a good recession in these areas will purge the excesses. My answer is simple – you are getting that anyway. The authorities have done quite enough on both sides of the Atlantic to so tighten credit that property prices are falling and will fall further. Mortgages are much scarcer than before, builders are losing their jobs – for the masochists among you who want more pain you will see plenty of it.

My advice to loosen conditions is based on wanting to limit the time of the downturn and to give people some hope of improvement in due course. For every “greedy” financier my critics may be cheering to see under pressure there will be several builders out of work. This sharp correction of prices and sharp reduction in the availability of new credit will not just hurt a few well paid people in the City that always have their critics. It is hurting many others, and will hurt many more, as the effects ripple out through estate agency, surveying, building, DIY, home furnishing and all the other trades dependent on a strong housing market.

Even the puritans thought there came a point where the punishment had purged the sin. Those who want the authorities to let more mortgage businesses go to wall are the advocates of deep recession. I want to start looking forward to recovery. There will be job losses and price falls enough for all save those who think all lending is an original sin that requires perpetual suffering.

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  1. Kit
    Posted July 14, 2008 at 9:08 am | Permalink

    Why do politicians always chose recovery now and inflation later? Don't answer that the answer obvious.

  2. Matthew
    Posted July 14, 2008 at 9:28 am | Permalink

    Well, if the UK authorities decided to deal with Northern Rock a la Fannie and Freddie they would simply give the company an implicit government guarantee not available to other mortgage providers and tell it to go and get new business. That might just work.

    I wonder what other commenters here think about whether it is time for the Conservatives to consider the reintroduction of mortgage interest tax relief? I think this would cost about £5bn – £10bn a year and would provide tax relief to 15-20m families.

  3. crown
    Posted July 14, 2008 at 9:35 am | Permalink

    Once people realise that mortgage lending has returned to normal after years of abnormal lending, we will be able to put this whole sorry affair behind us.

    Let it never be forgotten the Gordon Brown ruled the treasury at the time when lenders were allowed to lend like crazy fools under a regulator that is totally useless and a totally inept government.

    Remember how much grief Gordon gave the Tories for pension misselling?

    See here

  4. Matthew
    Posted July 14, 2008 at 9:36 am | Permalink

    A bit of research has found that John Redwood made restoration of MIRAS (ie at the time restoring it to its full rate) one of the main themes of the mid-1990s, including his leadership bid. So the issue might have traction.

  5. APL
    Posted July 14, 2008 at 9:38 am | Permalink

    JR: "My answer is simple – you are getting that anyway. The authorities have done quite enough on both sides of the Atlantic to so tighten credit that property prices are falling and will fall further. Mortgages are much scarcer than before, builders are losing their jobs.. "

    Ah! the variation of "we must not talk ourselves into a recession". Really, Mr Redwood. We are all here commenting on current affairs, very very few of us are in a position to influence events, no amount of platituedes and reassurance, even if that is what people want to hear, will change the course of events now.

    Fanny Mae and Freddy Mac are GOVERNMENT SPONSORED organisations, they are rotten to the core and those two things are not a coincidence. A Tory ought to be pointing that out.

    JR: " for the masochists among you who want more pain you will see plenty of it."

    Not masochists, realists.

  6. a-tracy
    Posted July 14, 2008 at 11:01 am | Permalink

    "there will be several builders out of work". Wouldn't this be a good time for the Olympic organisers to get moving on the building of the Olympic village and stadium to redeploy many of these workers. If they built an accommodation block first, the builders from out of area could live there Mon to Thur. It would be quite unique to get something built on time and in budget for a change.

  7. Robert
    Posted July 14, 2008 at 11:55 am | Permalink

    No one I hope, thinks that either lending or borrowing is an original sin! An appropiate understanding of risk/reward and the concept of not over-stretching oneself to have it 'now' would have meant a large number of people being in a much better position to withstand this downturn. The masochists probably feel that the economy/consumer (I am grossly generalising here) gorged themselves at the table of unsustainable borrowing and that buy to let and 'investing' in the housing market etc, were a one way bet. Anyone with a modicum of good sense should realise that borrowing against inflated prices (the housing market bottomed in '92-93 in London) on grossly inflated multiples could leave you open to a major problem in a downturn. No one I am sure wants people to suffer, but individuals have to be reponsible for their actions. The last 7-8 years of the UK's growth has primarily been driven by consumption, financed by increasing indebtiness based on rising asset prices and a massive increase in spending by government based on taxation and government debt (don't even get me onto the issue of the huge expansion of government employees). This is why we are the most vulnerable economy in G8 and why our currency will continue to be weak and will have further to fall, potentially importing further inflationary pressures. I would also point out it takes two to tango' – for every greedy financier there is a 'greedy' borrower. The one inescapable truth is that this crisis will, and is altering the Bank's business models for the future, though the cynics amongst us will say only until the collective memory fades, and 'greed' gets the upper hand again! The necessary rebuilding of both the banks, government, and personal sector balance sheets is going to take a number of years (2-3 years at least?) and this will result in lower economic growth for sometime to come. With regard to loosening monetary policy, I would agree that it may be appropiate to do this in the Autumn if we see no evidence of wage inflation, particularly in the public sector, that is not covered by 'productivity' growth. Even the monetarists who were so wildly condemned and ignored ahead of the debt bubble are now advocating a reduction in base rates, whether much of this is passed on in the short term would remain to be seen due to the shrinkage in capital. This bubble was not based on a 1 to 10 traditional leverage model but in some cases a 1 to 70 or even a 1 to 90 leverage basis, this will take time to fill! Obviously, for those with capital/cash there are going to be great opportunities over the next few years particularly if we hopefully manage to avoid deflation, so I am optimistic that there will be a recovery but it will be long and hard and sometime away, though as ever the markets will rise in anticipation, usually providing a 18-24 month lead to the change in direction of unemployment.

  8. cityunslicker
    Posted July 14, 2008 at 2:39 pm | Permalink

    A great post this – a near perfect summation of all the wrongs committed over Northern Rock.

  9. Matthew Turner
    Posted July 14, 2008 at 5:58 pm | Permalink

    Clive Crook has a slightly different take on Fannie and Freddie which is worth reading.

  10. Matthew Reynolds
    Posted July 14, 2008 at 7:15 pm | Permalink

    What is happening in the US & UK is a rebalacning of the economy away from debt fuelled consumption towards exports and industry . The US is making a better fist of it as their budget deficit is lower as a share of GDP thus making sure that some stimulus in the form of tax cuts can be provided to ease this transition . Relying on imports , a rising PSBR & rampant levels of personal debt is unsustainable – in the context of a flawed & complex system of financial regulation & monetary policy it is just folly . The chickens have come home to roost – I do not gloat as I fear the results .

  11. Matthew Reynolds
    Posted July 14, 2008 at 8:15 pm | Permalink

    What is happening in the US & UK is a rebalacning of the economy away from debt fuelled consumption towards exports and industry . The US is making a better fist of it as their budget deficit is lower as a share of GDP thus making sure that some stimulus in the form of tax cuts can be provided to ease this transition . Relying on imports , a rising PSBR & rampant levels of personal debt is unsustainable – in the context of a flawed & complex system of financial regulation & monetary policy it is just folly . The chickens have come home to roost – I do not gloat as I fear the results .

  12. Derek
    Posted July 14, 2008 at 10:25 pm | Permalink

    "I want to start looking forward to recovery".

    I hope you've got a powerful telescope.

  13. William B.
    Posted July 15, 2008 at 1:00 am | Permalink

    I have tried gamely to understand what the government did wrong in its handling of Northern Rock, but am not sure I really understand the criticisms all these months later.

    On the face of it there were three options open once NR ran out of money: (i) let it fold, (ii) lend it the money it was unable to raise on the markets in the hope it could trade its way out of trouble or (iii) buy the business (i.e. nationalise it).

    The first option was decried as dangerous and impractical because it would cause a loss of confidence in British banking as an institution. But since a major mortgage lender was bust it is hard to see that confidence was anything other than overstated. On a political level the more important issue was not confidence in British banking but confidence in the British government. Savers with Northern Rock had placed their liquid assets with a company which was thriving on a bubble of the government's making. Had it folded they would not just have lost their attractive returns but their capital itself might have been in danger. There were votes to be lost by the bubble bursting all over sensible people with savings.

    The second option was tried but by then the bubble had been exposed, at least to the satisfaction of the savers, hence the "run" on the bank. Other banks also took emergency loans from the Bank of England but Northern Rock was different from the other major mortgage lenders because its business was a bubble on a bubble.

    There was the national bubble of feel-good synthetic wealth … "look darling, we have made an extra £20,000 on the value of the house this month let's have dinner at Granita". That bubble existed no matter who lent the money to buy the property. Northern Rock's supplementary bubble was caused by its appallingly risky business model. It engaged in far too much equity lending, giving little heed to the value of the borrower's personal covenant to repay. And it did so because the taps were open; money could be borrowed in seemingly endless amounts on the money markets, then lent at a narrow margin and presented as secure (on paper) because the equity in the property was rising and rising. There was risk at both ends – the raising of the money and the lending. Other banks could have followed this model but the others had learned from the 1989-92 crash and were much stricter about proof of income and loan-to-value ratios (still too lax on both counts, however) and their businesses were not so highly concentrated on domestic mortgage lending.

    In the end the third option was inevitable. The government can be criticised for taking a little longer than necessary to get there, but that seems rather unfair to me because the run on the bank was halted by emergency lending – the very same system of emergency lending which was used by other banks with less risky business models – and government guarantees. The panic was over. Had the government given those interested in taking over Northern Rock 6 weeks rather than 3 or 4 months to formulate their bids it is a matter of conjecture whether the result would have been any different.

    I see no difference in substance between the guarantees the government gave Northern Rock in October last year and the guarantees the US government has given the troublesome siblings, Fannie and Freddie. Both expose the taxpayer to huge risks and do little if anything to improve the business model of the equity lender.

    By all means criticise the government for creating the initial bubble, a bubble which has been exposed more and more as the months have passed. By all means also criticise the government for not acting as fast as it could have done, but in making this latter criticism one must ask whether faster action would have improved the situation. If we are in exactly the same situation as if the government had been Linford Christie rather than Fatty Arbuckle, the criticism is empty.

    To criticise the government for taking over Northern Rock and then restricting its ability to lend is, in my view, equally unfair. Quite apart from the need not to use the might of the public purse to gain unfair advantage (a need which is both political and legal), it was essential to cut back on much of the core business because they were lending too much to people who could not afford to repay them. That part of the market simply had to be reduced.

    If I might say so Mr Redwood, I feel your article today exceeded legitimate criticism of the government. But don't worry, I'll agree with you, as usual, tomorrow and we can surely both enjoy a steady run of arrant knee-jerk nonsense from Mr Brown and his merry incompetents in the months ahead.

    In other guise I have predicted what is to come under this government:

    Reply: If you want to see my contemporary criticisms before the run on the Rock then look under the Rock tab on this site. I recommended a fourth way – keeping the markets more liquid in August/september 2007 so the Rock could borrow the money it needed.

  14. anon
    Posted July 15, 2008 at 8:56 am | Permalink

    So, how long have you been a socialist John?

  15. Robert
    Posted July 15, 2008 at 12:14 pm | Permalink

    With reference to your reply to the last posting , I fear you have underestimated the liquidity/capital that would have been required. Though I understand early invention can sometimes have more impact.

  16. Matthew
    Posted July 16, 2008 at 9:14 am | Permalink

    Willem Buiter also thinks the Fed and Treasury have made a mistake

  17. APL
    Posted September 8, 2008 at 9:15 am | Permalink

    Monday 8 August.

    Fannie & Freddie to be nationalised. Costing the US tax payer $500b now and heading for 1T in due course.

    lets see how the dollar reacts on the news.

  • About John Redwood

    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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