Jeremy Warner's Outlook: Freddie and Fannie not yet out of the woods

American legislators had been hoping that Freddie Mac and Fannie Mae would be part of the solution to the beleaguered US mortgage market. Only a little while back, the strict rules governing what type of mortgages Freddie and Fannie were allowed to securitise were relaxed a little in an effort to re-start the US housing market. Yet now they have become very much a part of the problem. Is there no end to the extraordinary loss of confidence that has engulfed financial markets over the past year?

The promised infusion of new equity and credit from the Federal authorities is obviously a positive development for markets, even if the US Treasury had little choice – it is unthinkable that these two organisations, together accounting for around half of the domestic mortgage market in the US, could be allowed to go to the wall. But the hope expressed by the US Treasury that in practice there may be no need for a bail-out, that merely saying the facilities are there as a backstop will be sufficient to restore confidence, may be over-optimistic. Nor is it entirely correct to think of the problems that have beset Freddie Mac and Fannie Mae over the past week as just a crisis in confidence that can be made to go away by saying the US government stands ready to do whatever it takes. Regrettably, the problem goes much deeper.

Last week's meltdown in the share price was sparked by remarks from Bill Poole, a former president of the Federal Reserve Bank of St Louis. His was the simple observation that if you apply "fair value accounting" to Freddie Mac's books, then because of the way mortgage securities have fallen in value, there is a big capital shortfall. As he himself pointed out, this is not such an uncommon feature of banking crises. As markets fall, they tend to overshoot, making banks seem critically under-capitalised.

The difference is that, whereas in the past banks have been able with the connivance of regulators to sweep these problems under the carpet, thereby muddling through until prices recover, modern accounting rules require much greater transparency. Losses have to be recognised immediately. Some bankers believe this has seriously enhanced the seriousness of the crisis, forcing unnecessarily large impairment charges and recapitalisations on banks. The enforced disclosure of losses has also plainly contributed to the collapse in confidence in the banking system as a whole.

Freddie Mac and Fannie Mae tend to hold their mortgages to maturity, so over time they would expect to get all their money back, together with accumulated interest. There is therefore no need to panic.

Yet though there may now be a degree of overshoot in the price of mortgage risk, in part caused by forced disposals at fire-sale levels, the market price is not an entirely irrational one. It reflects not just the fact that buyers of this risk are now much scarcer, but also a growing belief that the mortgage market may have changed fundamentally never to return to the way it was, or not for the foreseeable future, anyway.

The idea that Freddie and Fannie are pure free-market entities owned and governed by their shareholders is just a charade. In fact, they were only privatised in the late 1960s, in part for the purpose of getting responsibility for mortgage finance off the Federal government's books so as to free up money for the Vietnam war. But, as "government-sponsored enterprises" (GSEs), they continued to carry an implicit Federal guarantee. This has enabled them to raise finance for mortgages at something close to the rate paid by the government itself for debt. Many investors see them as the equivalent of US Treasuries, so much so that roughly a fifth of their outstanding $5 trillion of loans is held by foreign governments such as China and the oil-producing countries of the Middle East.

The effect is the same as a giant Federal subsidy constantly being infused into the US mortgage market. By making mortgage finance much safer than it perhaps really is, these two organisations have helped inspire the global property boom.

Freddie and Fannie are meant to finance only the best quality mortgages. So-called Alt-A and sub-prime mortgages are left entirely to the market, as indeed are all mortgages in Britain (Northern Rock now excepted).

Yet the securitisation techniques that Freddie and Fannie pioneered have been applied universally, and as such they have been at the heart of the explosion in mortgage liquidity that has helped finance the housing bubble worldwide. That's now gone. Eventually it will reopen, but in different form.

As the mortgage famine here in Britain has made us painfully aware, there won't be so much of it, and it will also be more expensive. This is already producing a self-fullfilling correction in house prices which, with the exception of one or two hotspots, is fast turning into a global phenomenon.

Even Freddie and Fannie, with their government guarantees, will have to recognise that mortgage finance has been repriced, possibly on a permanent basis. In the meantime, they are certain to need more capital to keep lending at all.