Run on banks spells big trouble for US Treasury

IN A modern financial system nothing is more frightening than a run on the bank. The US has now suffered a series of them, and they are escalating in size and scope, posing a serious threat to an already reeling economy.

Rumours swamped financial markets on Friday that the US Government would be forced to step in to aid the mortgage finance giants Fannie Mae and Freddie Mac, which together own or guarantee $US5 trillion ($5.16 trillion) in US home loans.

In Wall Street’s version of a run on the bank, investors drove Fannie Mae and Freddie Mac shares to 17-year lows, signalling a gnawing lack of faith in the companies’ ability to survive rising mortgage defaults without the Government’s help.

Later on Friday regulators took over IndyMac Bank of Pasadena, saying the $US32 billion lender had collapsed under the weight of bad home loans and withdrawals by spooked depositors. It was the second-largest bank to fail in US history.

Friday’s events were felt around the world, knocking the battered US dollar lower and driving up interest rates.

“This is a flare-up in the financial forest fire that is far beyond anything we’ve seen before,” said Christopher Low, chief economist at the investment firm FTN Financial in New York.

It is triggering worries that would have been unthinkable even a year ago, including that the US Treasury’s debt might lose its AAA credit grade because of heavy blows to the nation’s fiscal health from the housing mess.

Four months ago many on Wall Street believed they had seen the worst of the credit crisis rooted in the housing market’s woes. The collapse in March of the brokerage Bear Stearns, a central player in the business of packaging dicey mortgages for sale to investors, was the kind of prominent calamity that has historically marked the end of financial crises.

The Federal Reserve reacted quickly, making cheap loans available to loss-ridden banks and, for the first time, to securities firms. The moves helped restore calm to markets by April.

However, by May the focus of investors had returned to the slumping housing market and the likelihood that banks and brokerages would face more losses on mortgage-related debt. Confidence fell again.

Worse, in April the price of oil began a stunning climb that still has not relented. Record energy costs, coupled with surging food prices, raise the risk that more consumers could fall behind on their mortgage payments. The stockmarket’s decline has continued apace since and Wall Street is officially in a bear market – meaning a drop of at least 20 per cent in key stock indices – for the first time since the plunge of 2000-02.

There are parallels between that period and the present one that hint at worse to come. The stockmarket crash in 2000 began with the bust in dotcom stocks. This time, the decline began with the drop in home prices and its disastrous effects on every industry tied to housing.

In 2002 weary investors were hit by a wave of corporate accounting scandals. They simply felt they could not trust what many companies were telling them about their sales or earnings. Share prices dived further.

This time the crisis of confidence is in the US banking system. Fearing more severe losses than they have already suffered, investors in recent weeks have fled stocks of some of the US’s biggest financial institutions at a pace that has stunned Wall Street. Last week they turned with a vengeance on Fannie Mae and Freddie Mac.

Despite the companies’ assurances that they had adequate capital cushions against surging defaults on the mortgages they own or guarantee, the market does not believe them.

For the Government that poses a quandary. Because of their size and importance to the mortgage market, it is inconceivable that Fannie Mae and Freddie Mac would be allowed to fail. But an outright takeover of the companies by the Government, as some experts have suggested, could frighten foreign investors – who are big lenders to the Treasury – by in effect adding the companies’ $US5 trillion debt load to the Treasury’s already substantial debt.

Nationalising the companies “would put the full faith and credit of the Treasury at risk”, said Allen Sinai at Decision Economics in New York.

“It would make foreign investors think hard about buying US Treasury debt.”

The way you stop a bank run is to restore confidence. For the US, the challenge is not just to restore confidence among Americans, but to make sure it does not evaporate among foreign creditors.

Tom Petruno
July 14, 2008

Source: The Sydney Morning Herald

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