Time for US to get its financial house in order

PUBLISHED : Wednesday, 10 September, 2008, 12:00am
UPDATED : Wednesday, 10 September, 2008, 12:00am

US Treasury Secretary Henry Paulson has lamented that he did not leave investment bank Goldman Sachs to go to Washington to espouse government intervention in the financial markets. But there was no alternative to the massive federal rescue he announced for the troubled mortgage giants Fannie Mae and Freddie Mac.

Allowing these two government-sponsored enterprises to default on their debts would have posed systemic risk to the global financial system, damaged the credibility of the US government and undermined confidence in the US dollar. Intervention was necessary to protect the stability of financial markets. The crisis, however, should not have been allowed to develop. It is time for the US to get its financial house in order.

Buying up mortgages from banks and off-loading them to investors who are after a stable income stream is an ingenious idea that Fannie Mae and Freddie Mac have taken on as their mission. As US-government-sponsored enterprises, the bonds they issue carry an implicit government guarantee. Unfortunately, in trying to maximise profits, the managements of Fannie and Freddie failed to balance shareholders' interests with the need to maintain a safe capital reserve for their guarantee of thousands of billions of dollars of mortgages. When the sub-prime mortgage crisis sent defaults soaring and credit markets into turmoil, they struggled to raise the extra capital needed to cover their guarantees.

By effectively nationalising the two mortgage houses, the US government has made good the implicit guarantee it has given to bond holders. This is important as it is on the basis of this guarantee that the bonds have been seen as a reliable investment by both Americans and foreigners, including governments and central banks. Had Washington failed to come to the rescue, it would have undermined international confidence in its prowess and led to a global financial meltdown. The takeover will help steady the financial markets. But the US housing market is a long way from recovery. An assured flow of lending may slow a needed price correction that will make houses more affordable and reduce the risk of default. The US government will have to borrow heavily to finance the bailout, raising fears of a budget deficit blowout and pressure on mortgage interest rates. No wonder that stock markets around the world, after the rally in the wake of Mr Paulson's announcement, retreated yesterday as they weighed the uncertainties.

The US likes to lecture other countries on how to manage their finances, stressing the need for fiscal prudence, deregulation of financial markets and government non-intervention. But it needs to set a better example. Ten years ago, the US government stepped in to avert a financial crisis sparked by the miscalculations of the hedge fund Long-Term Capital Management. The more recent housing bubble has been blamed by critics on interest-rate mismanagement by the US Federal Reserve, which has also stepped in to rescue investment bank Bear Stearns. Now, the US government is acting to save Fannie Mae and Freddie Mac.

For the sake of the health of the global economy and the stable operation of the financial market, the US must improve the management and oversight of its financial industries. Controls need to be imposed on the dubious business of off-loading risks to unsuspecting investors, who also need to be educated to appreciate that they may have to pay for the supposedly safe, but potentially enormous, risks they are asked to undertake.