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Dow Jones dives as Hank Paulson rules out rescue of Fannie Mae and Freddie Mac

Posted by seumasach on July 12, 2008



“It is unclear if Mr Paulson can delay a state bail-out for long. “There is concern that Fannie, Freddie, and Lehman will not be around on Monday,” said one analyst.”

Ambrose Evans-Pritchard

Daily Telegraph

11th July, 2008

The Dow Jones index has plunged below 11,000 for the first time in two years in a fresh rout of bank shares after US Treasury Secretary Hank Paulson dashed hopes for an imminent bail-out of mortgage giants Fannie Mae and Freddie Mac.

The share price of the two fortress institutions – which together cover half the $12 trillion (£6 trillion) US home loan market – continued their collapse, losing another 20pc in wild trading. Fannie Mae has fallen 87pc since October, shedding $63bn. 

The meltdown at the two federally chartered agencies amounts to a heart attack at the core of the US credit system, leaving it obvious that the Bush administration has failed to stabilise the financial system since the Bear Stearns collapse in March. In a terse statement, Mr Paulson said the Treasury was working on a plan to bolster the two agencies in their “current form”. 

Press reports had suggested an explicit US guarantee of the agency debt, or even a state seizure known as “conservatorship” that would purge management and burn shareholders.

The Dow Jones plunged 251 points to 10,977.7 before recovering to close only 128 points down. After the market closed, Freddie Mac said in a statment: “We are not under any mandate to raise capital in the near term. Freddie Mac’s liquidity position remains strong.”

The events in the US hit banking shares hard in London, and helped drive the FTSE 100 deep into bear market territory, with the blue-chip index down 145.2 points – 2.69pc – to 5261.6. The FTSE 100 has now fallen 1470.8 points or 21.8pc from last June’s high of 6732.4.


The dollar also came under pressure, falling more than a cent against the pound to $1.9884 and saw oil prices climb to a record $147 a barrel, before easing back to nearer $145 in late trading.

US analysts estimate that Fannie Mae and Freddie Mac would need to lose a further $77bn to fall below the “critical capital level”, but the markets are already starting to anticipate even greater losses as US housing defaults soar.

As the fears of a banking crisis gripped Wall Street, Lehman Brothers shares fell 22pc. Investors have been spooked by a filing this week showing that the bank still has $41bn of mortgage debt and other “toxic” Level III assets.

Lehman now risks the same spiralling loss of confidence that engulfed Bear Stearns, though the Federal Reserve’s emergency lending window for broker-dealers offers a lifeline.

The credit default swaps on Lehman debt leapt 55 basis points to 380, flashing an extreme stress signal.

The implosion of Fannie and Freddie is disturbing. Neither has exposure to sub-prime loans.

“The situation is far more serious than Bear Stearns,” said Bill King, chief strategist at Ramsey King Securities.

Under the US stimulus plan the pair have been deployed as lenders of last resort to the housing market, carrying out a quasi-official rescue mission on behalf of Congress since March. Now the rescuers themselves need rescuing.

Charles Schumer, chair of the Senate banking committee, said: “Fannie Mae and Freddie Mac are too important to go under. If they need additional support, Congress will act quickly.”

If Washington does take on the liabilities of the two, this would double the US Treasury’s outstanding debt load at a stroke and raise serious concerns about the triple-A sovereign rating of the US itself.

There may be no choice. Bill Gross, head of the bond giant Pimco, said a default by the two agencies would set off a “firestorm of intolerable proportions”.

Standard and Poor’s said in a recent report that Fannie and Freddie posed “a large contingent fiscal risk: if the risks were to translate into increased government debt, they could hurt US credit standing”.

The markets have already begun to sense danger. The cost of insuring against default on 10-year US Treasury bonds surged from 8 basis points to 15 at one stage yesterday.

“America’s ‘AAA’ rating has become a joke,” said Peter Schiff, head of EuroPacific Capital.

“I believe the losses from Fannie and Freddie alone could reach $500bn to $1 trillion dollars.

” The US government will not be able to meet repayments on its debt once interest rates rise,” he said.

Mr Schiff said a big chunk of the agency debt is held by foreigners. A collapse of confidence could set off a dollar exodus.

It is unclear if Mr Paulson can delay a state bail-out for long. “There is concern that Fannie, Freddie, and Lehman will not be around on Monday,” said one analyst.

Ironically, Fannie and Freddie shares, having halved in value at one stage, recovered slightly after Mr Paulson’s comments. Investors were relieved the agencies might yet be spared a state seizure aimed at limiting “moral hazard”.

This is what occurred in the Nordic financial rescues of the early 1990s, which left shareholders with nothing.

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