Failure of Financial Heavyweights Could Have Caused Markets to Implode

Until a few months ago few people on this side of the Atlantic had heard of Fannie Mae and Freddie Mac, the two government agencies that between them underwrite half the mortgages in the US. But as a result of Hank Paulson's rescue package at the weekend the importance of Fannie and Freddie, not just to the US home loans market but to the entire global financial system, became glaringly apparent.

The US Treasury secretary feared that the looming failure of the two firms as a result of the losses made on the imploding US housing market would send shock waves around the world. "Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe," Paulson said. It was a fear shared in the UK, where banks and pension funds have been big buyers of bonds issued by the institutions.

Why were Fannie and Freddie so important to the world?

The institutions issued bonds they marketed heavily to international investors. These bonds were attractive while the US housing market was strong, because they went up in value and were seen as the next best thing to US Treasury bills or government debt. They were bought by central banks around the world, by commercial banks looking for diverse portfolios and by pension funds, including those in the UK, looking for a safe home for their cash. The Bank of England allowed them to be used by banks in its emergency funding scheme designed to bolster the financial markets. Foreign investors increased their purchases of debt issued by Fannie and Freddie in recent years from $107bn (£61bn) in 1994 to an estimated $1.3trillion.

There were signs at the weekend that some of these investors were losing faith in Fannie and Freddie. They had cut their holdings of debt by about $18bn since a rescue package for the institutions was mooted in July, while putting more of their investments in Treasury bills. David Rosenberg at Merrill Lynch said: "This unprecedented liquidation by the foreign central banks represented a dramatic loss of confidence on the part of an investor class which ... is a critical capital provider for the American dream."

Government support means that anybody holding bonds in Fannie and Freddie has no risk of losing their money. That means that UK pension funds will emerge unscathed. It will be a different story for investors in the shares of the pair, where the pain will be deep and mainly confined to the US, where the authorities admit half a dozen banks could go bust as a result.

Fannie and Freddie stand behind most of the US banks.

Their role in the US financial system is crucial. They guarantee half the US mortgage market and provide support to small regional lenders as well as major international banking giants. They help to ensure there is enough financing to provide mortgages to would-be American home owners. In the housing market downturn their importance had become pronounced because as some lenders pulled back the two firms accounted for about 80% of new home loans. Paulson made it clear that as part of the government intervention housing finance costs in the US should be kept down for the next two years.

Will it make a difference to the UK housing market?

Quite what the impact will be on UK home owners remains to be seen. If the bailout of Freddie and Fannie bolsters confidence in the financial system then, eventually, UK mortgage lenders may again become more willing to grant home loans, though it could be a slow process.