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Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout

By William Patalon III
Executive Editor
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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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning. With his latest project, Private Briefing, Bill takes you "behind the scenes" of his established investment news website for a closer look at the action. Members get all the expert analysis and exclusive scoops he can't publish... and some of the most valuable picks that turn up in Bill's closed-door sessions with editors and experts.

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  1. DAN | September 11, 2008

    yes, and we americans are stupid and dont understand anything but sport stats and we keeping electing the liers and theives to congress to help us out of the terible postions that the same liers and theives put us in. go figure !

  2. Robert Freeman | September 11, 2008

    The possibility of the next Great Depression looms large and the Fannie and Freddie fiasco and similar occurences are the seeds of one. Where have the regulators been during the last 8 years of this catastrophic administration?

  3. Keith Jordan | September 11, 2008

    Given the fact that the goverment will do anything to ensure foreign debt buyers are protected and will continue buying, what can the average American Investor invest in to protect or make gains in the next 5-10 years?

  4. Joe Christie | September 11, 2008

    From a purely economic policy standpoint ( outside of politics) what should the US do to get out of debt?

  5. H. Craig Bradley | September 12, 2008

    Happy Slaves

    The "little people" that the late Sheila, Leona Helmsley famously referred to during her income tax evasion trial probably have little knowledge of these financial matters. To the average man/woman on the street, this is just "politics" and therefore does not matter much.

    Such widespread attitudes and denial are precisely why all these government bailouts happened. Of course, it is far easier for the average 'munchkin' to blame President Bush for it all because he is so "stupid". In reality, he was only complacent, but no more complacent than many fellow American citizens.

    The public press (media) prefer to currently dwell on such serious issues as Obama's comments about Sara Palin and references to a "pig with lipstick". In such a manner, the mind of John Q. Public is filled with endless trivia.

    Certainly history repeats, but not exactly. Take the Battle of Hastings in Oct. 1066. The Normans decisively defeated the English armies. However, the common people (serfs) scarcely noticed any differences.

    The King of England (killed) and his top nobles and barrons were replaced by others. Thereafter, Finance and architecture were directed differently. Subtle changes slowly occurred, such as buildings with different design and architecture. Gradually, change developed, but most serfs (commoners) never really noticed it.

    Today, our foreign wars are being replaced by financial servitude. The taxpayer will pay, and think it is for the good of the country. Old ideas die hard. Our politicians have already sold out the taxpayers who have little recourse left. They must pay- and pay more they will.

    The Book of Proverbs says it correctly : "The borrower becomes the lenders slave". Truth is timeless.

  6. robertsgt40 | September 12, 2008

    That's why the Fed was created in the first place…to transfer the nation's wealth into a small number of hands. It's called long tern theft.

  7. H. Craig Bradley | September 13, 2008

    Back in the seventies, Pierre Rothschild made a killing on the financial mistakes of then President Jimmy Carter. High inflation and a cheap dollar benefit certain types of people (vultures).

    Now, I understand SOME people won't appreciate my comments. Fortunately, it is protected free speech and there is little (nothing) they can do. So accept these comments and if you find them displeasing, ignore them.

    In ANY event, they will continue forever and in many forms (verbal, written, e-mail, hard copy). So sports fans, if you don't like what you read or hear from me, then feel free to "lump it". Either way, I don't much care what the public thinks, or says.

  8. WILLIAM G. FOWLER, M.D. | October 10, 2008

    I would be interested in buying FNM and AIG at current prices, but only if there is a chance for long-term gain. When the govt. shafted the small investors in common stock, it cut its own throat.

  9. George | September 23, 2009

    Let's see….An investment bank "makes" 10b year one, and pays out 1b in bonuses. Year two, it "makes" another 10b and pays out another 1b. Same thing year three. Year four, as a direct result of it's (basically fraudulent) activities of the preceding three years, it looses 100b, and gets bailed out by the tax payers, and pays another 1b in bonuses?! I'm concerned that revolutions are born from this kind of stuff!

Trackbacks

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    […]    o o o Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout […]

  2. […] The financial-sector convulsions that started in the summer of 2007 already have eliminated The Bear Stearns Cos., which in March was forced into a government-supported, cut-price sale to JPMorgan Chase & Co. (JPM). Last weekend, the U.S. Treasury Department took control of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) – placing them into a conservatorship – after concerns that foreign central banks would stop buying our bonds actually forced the government’s hand [For a full report on that dilemma, take a look at our report, Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout]. […]

  3. […] The financial-sector convulsions that started in the summer of 2007 already have eliminated The Bear Stearns Cos., which in March was forced into a government-supported, cut-price sale to JPMorgan Chase & Co. A week ago, the U.S. Treasury Department took control of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) – placing them into a conservatorship – after concerns that foreign central banks would stop buying our bonds actually forced the government’s hand [For a full report on that dilemma, take a look at our report, Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout]. […]

  4. […] investment banks, insurance companies, hedge funds and all manner of other duped and unsuspecting investor entities worldwide, as well as the proliferation of the unregulated $62 trillion credit default swaps (CDS) […]

  5. […] investment banks, insurance companies, hedge funds and all manner of other duped and unsuspecting investor entities worldwide, as well as the proliferation of the unregulated $62 trillion credit default swaps (CDS) […]

  6. […] Ever since it became clear that 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, it was just as clear that the credit crisis was no longer just a domestic affair [For the full story on the U.S. government’s decision to take control of Fannie Mae and Freddie Mac, check out this special Money Morning investigative report.] […]

  7. […] Ever since it became clear that 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, it was just as clear that the credit crisis was no longer just a domestic affair [For the full story on the U.S. government’s decision to take control of Fannie Mae and Freddie Mac, check out this special Money Morning investigative report.] […]

  8. Credit default swaps: The Real Reason for the Global Financial Crisis...the Story No One's Talking About. | triggereventstrategist.com says:

    […] Money Morning Market Analysis: Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout. […]

  9. […] investment banks, insurance companies, hedge funds and all manner of other duped and unsuspecting investor entities worldwide, as well as the proliferation of the unregulated $62 trillion credit default swaps (CDS) […]

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