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Foreign
Bondholders Drove the
Fannie/Freddie Bailout
By William Patalon III
Executive Editor
11/09/08 "Money
Morning/The Money Map Report"
-- For anyone who still doubted the growing global influence
of such emerging powerhouses as China, consider this: The U.S.
government’s decision to take control of foundering mortgage
giants Fannie Mae (FNM) and Freddie Mac (FRE) was driven not by
worries about the fading U.S. housing market, but by concerns
that foreign central banks in China, Japan, Europe, the Middle
East and Russia might stop buying our bonds.
As the bailout announced Sunday is currently structured, more
than $1.3 trillion worth of Fannie Mae and Freddie Mac debt
currently held by the central banks and other investors in those
regions will be guaranteed by the U.S. government - even if one
or both of the two government-sponsored enterprises (GSEs) were
to fail. That means that U.S. taxpayers - government parlance
for you and me - will ultimately foot a big part of the bill for
making sure those foreign bondholders are “made whole.”
The government apparently felt it had no choice. As speculation
about the possible collapse of the two firms spiraled higher in
recent weeks, central banks, sovereign wealth funds and foreign
investors throughout the world were reportedly threatening to
halt their purchases of Fannie and Freddie debt, grousing that
the mounting risk was making them leery of buying any more
bonds. And that would make it virtually impossible for the two
mortgage operators - and by extension, the U.S. mortgage market
- to function effectively.
“It was the mounting evidence that central banks, sovereign
wealth funds, and other global investors were growing
[increasingly] reluctant to invest in the debt that was the
catalyst for the Treasury Department’s actions,” Mark Zandi,
chief economist for Moody’s/Economy.com in West Chester, Pa.,
wrote in a recent research report. “Fannie and Freddie debt is
now effectively U.S. Treasury debt, ensuring that holders will
remain whole.”
Fannie and Freddie together own or guarantee about half of the
country’s $12 trillion in mortgage debt. On Sunday, however,
Federal Housing Finance Agency Director James Lockhart said the
two companies’ market share of newly issued mortgages had
actually exceeded 80% earlier this year, before falling off
recently.
And yet, that wasn’t the mortgage market itself that forced the
hand of U.S. Treasury Secretary Henry M. “Hank” Paulson: It was
the $5.2 trillion in so-called Fannie and Freddie “agency debt”
- of which more than $1.3 trillion, or about 25%, was held by
foreign investors. Total U.S. agency debt of all types was said
to be slightly more than $1.5 trillion.
Without the bailout, China’s
financial position may have been damaged: Of that country’s $1.8
trillion in foreign currency reserves, as much as 70% is held in
dollar-denominated assets.
With $376 billion in GSE debt, China was also the top holder of
the bonds issued by Fannie Mae and Freddie Mac.
If China were to lose confidence in the U.S. currency - dumping
the dollar - it’s hard to say with certainty just how bad things
could get. Should foreign investors rampantly discard the
dollar, the greenback would plunge against other currencies.
And that would be highly inflationary, translating into what
would effectively be big price increases on such key imports as
oil, steel, electronics, and other wares.
That could finally force the U.S. Federal Reserve to raise
interest rates - a move the central bank has been trying to
avoid, due to concerns that markedly higher rates would shove
the U.S. economy into a deep recession.
So it’s not surprising that the Treasury and Fed took very
seriously any concerns about the Fannie-and-Freddie debt
situation that were expressed by central bankers from around the
world.
In an interview with The Washington Times, Council on Foreign
Relations Geo-Economics Fellow Brad Setser said the federal
bailout proposal is a remarkable development.
“I suspect this is the first case where foreign central banks
exercised their leverage as creditors to push the U.S.
government to make a policy decision that protected their
interests,” said Setser, who has tracked rising foreign
investment in Fannie, Freddie and other debt issued by U.S.
agencies.
It’s certainly an odd development: The bailout takes great pains
to protect foreign investors - even though common shareholders
will be wiped out.
However, the consequences of a default on the debt “would have
been devastating,” former Treasury Secretary John Snow -
Paulson’s predecessor - told the Washington-based daily
newspaper.
“There is [now] relief around the world that the U.S. government
is standing behind this paper (debt),” Snow told The Times.
Two major China-based banks that together held $8 billion in
Fannie and Freddie debt early this week lauded the U.S.
government’s decision to back the debt issued by the two
mortgage firms.
“We think this is good for Fannie and Freddie because the U.S.
government used to be ‘invisibly’ guaranteeing them, but now it
is taking explicit action to [tacitly] guarantee them,” Wang
Zhaowen, a spokesman for the Bank of China Ltd., told
CNNMoney.com.
Tine Olsen, an economist with Moody’s/Economy.com, wrote in a
recent research note that because “the debt issued by Fannie Mae
and Freddie Mac is now essentially backed by the U.S. Treasury,
holders no longer need to fear losing their investments. A great
sigh of relief will have reverberated through the markets in
Asia when the U.S. Treasury injection of capital was announced.”
Such views of approval are by no means universal, however.
Capital to finance the bailout will have to come from somewhere,
and that somewhere is from taxpayers’ wallets.
Estimates of the bailout’s cost to taxpayers range from $100
billion to $300 billion. John Hussman, a fund manager and
president of Hussman Econometrics Advisors - and a
financial-sector expert I often cited as a news story source
during my years as a business journalist - this week said that
$250 billion was “a fairly conservative estimate.”
The problem, of course, is that the U.S. government has
established what could be a costly and ill-advised precedent -
the bailout. First it was The Bear Stearns Cos., now it’s Fannie
Mae and Freddie Mac and tomorrow it could be Lehman Brothers
Holdings Inc. (LEH).
And it’s not just the direct costs of the bailouts that are a
cause for concern. By backing the $5.2 trillion in
Fannie/Freddie indebtedness, the United States has essentially
doubled its public debt load.
That’s not just an idle worry, either. Once privatized, even
slimmed-down versions of Fannie Mae and Freddie Mac won’t be
anywhere near as easy to package and sell-off as was busted
investment bank Bear Stearns, which was bought out by JPMorgan
Chase & Co. (JPM).
Some have actually warned that the U.S. government could end up
being in the mortgage business - literally - for years.
The other option would have been to let Fannie and Freddie fail
and to take the economic pain now - instead of spacing it out
over a period of years, or even a decade. In a recent interview
with Money Morning, investing guru Jim Rogers warned that the
U.S. government has no business being in the bailout business.
FreedomWorks, a conservative non-profit organization that’s
based in Washington, characterized the Fannie Mae/Freddie Mac
bailout as a deal by politicians that’s nothing more than a
transfer of “possibly hundreds of billions of U.S. tax dollars
to sophisticated investors and governments overseas.”
According to FreedomWorks President Matt Kibbe, “the prospectus
for every GSE bond clearly states that it is not backed by the
United States government. That’s why investors holding agency
bonds already receive a significant risk premium over Treasuries
… a bailout of GSE bondholders would be perhaps the greatest
taxpayer rip-off in American history. It is bad economics and
you can be sure it is terrible politics.”
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