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/ 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

Tine Olsen, an economist with Moody's/, 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 at Money Map Press.

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