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Recession angst rules the waves

Fri, Sep 12 2008, 12:02 GMT
by HVB Group Global Markets Research

HVB Group

• US. Fear is spreading, i.e, the fear of economic contraction in the industrialized world. The US is still teetering on the brink of recession despite surprisingly strong Q2 GDP numbers: For the first time in 17 years, real private consumption is now in negative territory, and the so far brisk export growth will slow. It is still possible that the NBER will officially “proclaim” a recession (pages 4-6, 7-8 & chart below).

• Europe. The EMU economy should escape a recession only by a hair’s breadth – because the services sector is offsetting recession in industry. Following the GDP contraction in spring, the best France can hope for is minimal growth, and Italy even only stagnation. Germany, however, can no longer avoid the double whammy. And the UK is also sliding into recession (pages 9-11 & 12-13).

• Hope. Japan completes the recession camp. The only slivers of hope on the global economic horizon are a possible second US fiscal stimulus package, but above all the recent strong pullback of oil prices, since this is increasing consumers’ discretionary spending capability.

• Central banks. The inflation-dampening effect is, furthermore, creating scope for a (more) accommodating monetary policy. The Bank of England will initiate its easing cycle as early as November; the ECB will follow suit a few months later. And the Fed will probably have to retain its strongly expansionary interest rate policy even longer.

• Further topics:

  – Weekly Comment: The sound of inevitability (page 2).

  – Swiss National Bank: Sit back and observe (page 14).

  – Data outlook: ZEW marginally higher, Fed on hold (page 16).

  – Market outlook: A brief breather for the euro (page 22).

The sound of inevitability

The markets are currently gripped by fears of a global recession, and these fears have sparked a sharp rise in risk aversion. As this issue of our publication points out, we do in fact see vulnerabilities persisting in the US and a significant chance of a technical recession in the eurozone. But a technical recession should not be exaggerated. If you look at our forecast tables at the end of the publication, you will see that we still expect decent growth in both Europe and the US this year and the next, and our scenario is far from a global recession. The dramatic market reaction of recent weeks is driven mostly by a reaction to previous overly optimistic expectations. It was a reality check. The market has discovered that the rest of the world is not immune to the US’s problems. This is true, and we have been saying as much since the US economy started to decelerate. But it does not imply that a deep global recession is inevitable, and we believe the data do not justify the wave of panic currently gripping the market. Government intervention, of the kind discussed below, will gradually help stabilize sentiment.

Heeding “the sound of inevitability”, the US Treasury has de facto nationalized Fannie Mae and Freddie Mac, the Government Sponsored Enterprises that play a pivotal role in the US mortgage market. The intervention is aimed at supporting the housing market, with the Treasury directly fostering an improvement in mortgage affordability, and the financial market, which is heavily exposed to the GSEs’ bonds and mortgage backed securities. The plan should help restore recently flagging confidence in the US growth outlook, and it should inject a measure of confidence in the outlook for the financial system at another crucial juncture, ahead of feared quarterly results by major banks.

The key elements of the intervention are (cf. the Treasury’s statement: http://www.treas.gov/press/releases/hp1129.htm)

– The Federal Housing Finance Agency (FHFA) will take Fannie and Freddie under conservatorship;

– The Treasury will receive USD 1bn of senior preferred stock, reaching an 80% ownership stake in the GSEs.

– The Treasury will purchase up to USD 100bn in stock in each company as needed to keep them at positive net worth.

– The Treasury will also provide secured short-term funding to Fannie and Freddie as well as to 12 federal home loan banks

– The CEOs of Fannie and Freddie will be replaced, the dividends eliminated, existing shareholders obviously see their stock holdings diluted by the Treasury’s new preferred stock. This is the price exacted by the Treasury for its intervention, to minimize the bailout aspect.

– The Treasury will buy and hold mortgage backed securities from the GSEs.

– The GSEs’ portfolios of mortgage backed securities will be allowed to increase modestly through end-2009, to support mortgage finance availability. They will then have to be shrunk gradually but substantially from 2010.

Fannie and Freddie were a disaster waiting to happen, and long in the making: set up to support the development of the mortgage market and home ownership, they operated de facto as quasi-governmental agencies, benefiting from the market’s assumption that in case of trouble they would be bailed out by the government. A full forty years after the agencies had taken their current form, (seventy since Fannie’s birth) trouble has finally struck in the form of the subprime- triggered crisis. During the boom period of 2006-07, Fannie and Freddie underwrote increasingly risky loans, and suffered serious losses as a result. As their financial situation worsened, the GSEs found themselves unable to raise new capital, making government intervention inevitable. Paulson explicitly acknowledged the flawed governance model of the GSEs lies at the root of the problem and will have to be reformed.

The Treasury’s intervention was in the cards: most market participants have long agreed that a stabilization in the US housing market is a necessary precondition for resolving the financial and macroeconomic crisis. Paulson said as much this weekend: “Fannie Mae and Freddie Mac are critical to turning the corner”.

We see this move as unambiguously positive: the Treasury’s intervention will offer support to both the housing market and to the financial system, where a large number of investors world-wide, including central banks, hold Fannie and Freddie’s bonds and mortgage-backed securities, starting with USD 5bn. This intervention is explicitly aimed at reducing borrowing costs for homeowners. It is not a silver bullet, and it is of course not enough by itself to eliminate the significant fragilities that still persist – but it does take off the table a considerable downside risk, and significantly increases the chances that the incipient signs of stabilization that have emerged in the housing market will gradually be confirmed.

I had argued early on in the crisis that a public intervention similar in size and style to the Resolution Trust Corporation was needed, and it is gradually taking shape in a piecemeal and targeted fashion. Note that Treasury Secretary Paulson used very similar arguments to those made to justify the Bear Stearns operation: “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 finan cial markets here at home and around the globe.” The government has taken the baton from the Fed and is acting with measures targeted as much as possible to the housing sector and the financial system.

We will probably hear two criticisms in the coming days: first, that this intervention will be insufficient to halt the slide of the housing market and the ongoing deterioration of the financial system; and second, that by taking on Fannie and Freddie’s liabilities the US government will risk a sizable increase in its debt stock, possibly even threatening its AAA rating. Both arguments seem unconvincing. On the latter, the fact that the GSEs were grossly undercapitalized in no way implies that the share of their liabilities that will default will be large enough to jeopardize the sovereign’s credit standing. On the former, we have already seen some tentative signs of stabilization in the housing market and the economy is so far holding up better than expected – notwithstanding the latest nasty unemployment figure – and in this situation the government’s intervention in support of the housing market is likely to prove effective. This is not to say that our worries are over – quite the contrary. Uncertainty and risks to the economic and financial outlook persist and will continue to cause dangerous swings in market mood and actions; but this action by the US Treasury brings a much needed temporary sigh of relief.

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Published on  Fri, Sep 12 2008, 12:13 GMT