It's not over.
Investors may be tempted to see the government's takeover of Fannie Mae and Freddie Mac as the kind of cathartic action that marks a decisive turning point for the U.S. banking system and the wider stock market.
But the chief problem at Fannie and Freddie -- an inadequate capital cushion against losses -- also bedevils large banks in the U.S and Europe more than 12 months into the credit crunch.
While the capital shortage may not be as dire as at Fannie and Freddie, private banks can't count on a government rescue. Some will fail. Others will have to raise massive amounts of capital to shore up their shaky balance sheets.
Make no mistake, the government's move to shore up Fannie and Freddie will likely give markets a short-term boost, especially if investors believe this can help underpin house prices in the U.S. But this move by the Treasury comes just as a new, more general threat looms: On top of U.S. economic problems, underlined by Friday's jump in the unemployment rate, the rest of the world is slowing.
The broader strains now facing the markets are not as easily relieved by central banks or governments as the company specific crises at Fannie and Freddie or Bear Stearns earlier this year.
Of course, central banks could cut interest rates in the face of this threat. Even the Federal Reserve has some room to cut the Fed Funds rate from 2%. That may be one reason bank stocks rallied Friday in the U.S. despite the dismal unemployment figure.
Rate cuts would theoretically allow banks to harvest easy profits by borrowing more cheaply and lending to high-quality borrowers at attractive rates. The trouble is, banks are being extra cautious, justifiably, about lending as the economy slows.
The shakeout of the past year has done almost nothing to improve the average U.S. household balance sheet. So while a government commitment to buy mortgage-backed securities, also announced Sunday, may cause mortgage rates to fall, banks may not want to lend at lower rates because they don't feel they're being compensated for the risks in this uncertain economy.
And while banks are reluctant to lend, many are having problems borrowing to fund themselves. That is because the market's assessment of their creditworthiness is darkening.
A closely followed yardstick that measures the gap between interbank lending rates and the expected federal-funds rate has widened beyond July's distressed levels. When this gap widens, banks are perceived to be riskier.
Also, the cost of insuring against default by large banks is rising.
The takeover of Fannie and Freddie could even worsen that sentiment, as investors grow even more cynical of regulatory measures of capital.
For months, Fannie, Freddie, their regulator and other government officials have assured investors that measures of regulatory capital showed the mortgage firms weren't financially hobbled.
The government's takeover shows this wasn't the case. Given that, investors are going to want concrete actions from banks, not continued pronouncements that losses on mortgage-related securities are only temporary and will one day bounce back.
That will translate into highly dilutive issues of common stock, which will be necessary if banks are to raise capital to the levels required to reassure anxious funding sources.
And that is why bank investors who place too much hope in the bailout of Fannie and Freddie could get burned.
Peter Eavis / David Reilly |
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