Merrill Lynch warns US faces global funding crisis

Merrill Lynch has warned that the United States could face a foreign "financing crisis" within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world. The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700 billion current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst. Britain and other Anglo-Saxon deficit states could face a similar retreat by foreign investors. "Japan was able to cut its interest rates to zero," said Alex Patelis, Merrill's head of international economics. "It would be very difficult for the US to do this. Foreigners will not be willing to supply the capital. Nobody knows where the limit lies." Brian Bethune, chief financial economist at Global Insight, said the US Treasury had two or three days to put real money behind its rescue plan for Fannie and Freddie or face a dangerous crisis that could spiral out of control. "This is not the time for policy-makers to underestimate, once again, the systemic risks to the financial system and the huge damage this would impose on the economy. Bold, aggressive action is needed, and needed now," he said. Bethune said the Treasury would have to inject up $20 billion in fresh capital. This in turn might draw in a further $20 billion in private money. Funds on this scale would be enough to see the two agencies through any scenario short of a meltdown in the US prime property market. He said concerns about "moral hazard" -- stoked by hard-line free-marketeers at the White House and vocal parts of the US media -- were holding up a solution. "We can't dither. The markets can be brutal. We have to break the chain of contagion before confidence is destroyed." Fannie and Freddie -- the world's two biggest financial institutions -- make up almost half the $12 trillion US mortgage industry. But that understates their vital importance at this juncture. They are now serving as lender of last resort to the housing market, providing 80 percent of all new home loans. Roughly $1.5 trillion of Fannie and Freddie AAA-rated debt -- as well as other US "government-sponsored enterprises" -- is now in foreign hands. The great unknown is whether foreign patience will snap as losses mount and the dollar slides. Hiroshi Watanabe, Japan's chief regulator, rattled the markets on July 17 when he urged Japanese banks and life insurance companies to treat US agency debt with caution. The two sets of institutions hold an estimated $56 billion of these bonds. Mitsubishi UFJ holds $3 billion. Nippon Life has $2.5 billion. But the lion's share is held by the central banks of China, Russia and petro-powers. These countries could all too easily precipitate a run on the dollar in the current climate and bring the United States to its knees, should they decide that it is in their strategic interest to do so. Merrill Lynch said foreign governments had added $241 billion of US agency debt over the past year alone as their foreign reserves exploded, accounting for a third of total financing for the US current account deficit. (They now own $985 billion in all.) By most estimates, China holds around $400 billion, Russia $150 billion and Saudi Arabia and other Gulf states at least $200 billion. Global inflation is now intruding with a vengeance as well. Much of Asia is having to raise rates aggressively, drawing capital away from North America. This may push up yields on US Treasuries and bonds, tightening the credit screw at a time when the US is already mired in a slump.