Freddie and Fannie Bail-Out: Our Foreign Masters Have Spoken

Obviously, the big news is the government bail-out of Freddie and Fannie. Over the weekend I wrote two articles on this. Here's a link to the first article which provides a history of how we got here and here's a link to the second article which outlines the plan and explains why it's happening now.

There's one point that I think is incredibly important right now. I touch on it in the second article, but I'm not the one who presented a detailed analysis of how it happened. That distinction goes to Angry Bear:

Update: Market Watch

Consider the description of the bailout from the: New York Times:

Investors who own the companies' common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan. [italics mine]

Now consider the following from MarketWatch,

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."

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China alone holds $376 billion in bond holdings.

Unless I am misreading something, foreign central banks will be protected, including China's...and the America taxpayer will foot that bill.

Secretary Paulson has been busy of late reassuring foreign central banks that they will be protected.

In recent weeks, Treasury officials have been reaching out to foreign central banks and other overseas buyers of securities or debt sold by the two companies, to reassure them of the creditworthiness of these instruments.

In one such conversation, at the end of August, the Treasury sought to reassure the Bank of Mexico, according to a person familiar with the matter, of the soundness of agency securities held by the bank. Treasury officials have also had similar conversations with Japanese investors who are buyers and holders of agency debt.

.....

The meaning and ramifications of this collapse cannot be unravelled in a single post--or a hundred posts. Mismanagement, corporate greed and excess need examining.

Once again, the U.S. taxpayer will be asked to shoulder another mountain of debt. Once again, the taxpayer has become the prop of last resort as poorly managed entities become too big to fail. How long this can continue is the question.

Everything seems broken. No one seems to be safely in charge. Instead, I imagine public officials--Bernanke and Paulson-- racing frantically from meeting to meeting, making assurances, looking for the next band-aid.

John McCain wants Fannie Mae and Freddie Mac to shrink so that their size no longer is a threat. Would he say the same thing about Bear Stearns, albeit it is far smaller? Should Bear Stearns not have been allowed to grow so large? How do we shrink such a massive entities? Remember, they hold over $5 trillion in mortgages. Do we hold a fire sale? And would he apply the lobbying rule to other large companies? After all, they now have a heavy hand in writing the regulations that govern them. (The Medicare Part D fiasco is evidence of just how influential the pharmaceuticals were in deciding just what regulations were best for them.) Is it big government that is the problem--or big corporations that run the government?

Obama wants Fannie and Freddie out of the profit-making business. Is America ready for nationalizing such institutions? Is Obama? And could we have afforded a total collapse of Bear Stearns? Can the government simply allow such things to happen if the consequence for the nation is dire?

And how does the next president reassure our foreign creditors that the U.S. will pay its bills?

While we may be dismayed that foreign central banks will receive "government backing," we do not have much choice.

Yu Yongding, former advisor to China's central bank, put the matter bluntly:

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,'' Yu said in e-mailed answers to questions yesterday. ``If it is not the end of the world, it is the end of the current international financial system.''

Foreign central banks have been propping up the U.S. economy:

Foreign central banks have financed the United States to keep their export sectors -- heavily dependent on U.S. consumer spending -- humming. But they now must weigh the benefits of providing the United States with such "vendor financing" against the rising costs of keeping the current system going.

Yu Yongding is not making a threat; he is stating a fact.

If foreign central banks stop financing U.S. debt (there are no free rides), then the U.S. is in a world of hurt. As Brad Setser notes:

...in fact, the economic and financial risks that arise from the U.S. current account deficit (and the resulting dependence on foreign financing) have not been exaggerated. If anything, they have received too little attention -- and are set to grow in the coming years.

Well, "the coming years" may be sooner, not later. For the U.S., the consequences may be immediate inflation as Treasury attempts to makes its offerings more palatable. The dollar will plunge. And these are just for starters.

The party is over. Sorry that most of you working stiffs missed it. Oh, by the way, here's the bill.

As Paul Krugman said:

I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it's doing to an angry public.

Although the American public is not exactly happy with the economy, it has no idea of the depth of the problems. Most people think the government's check writing ability is infinite.

Well, the government is broke and broken.

This has everything to do with foreign central banks and investors (along with some incredibly large US investors like PIMCO) essentially detailing US policy. Note the following statement from today's WSJ:

Mr. Paulson noted that more than $5 trillion of debt and mortgage-backed securities issued by Fannie and Freddie is owned by central banks and other investors world-wide. "Failure of either of them would cause great turmoil in our financial markets here at home and around the globe," Mr. Paulson said.

Paulson has repeatedly cited foreign ownership as a reason for the intervention. But let's back up a bit to see how the current economy is really structured:

Above is a chart of the current account. All this means is the following: the US buys more stuff from abroad then we sell abroad. The problem is we don't have the money to pay for all of this. Why? Because the US savings rate is terrible:

Notice how the US is saving less and less. That means we have to borrow money to buy all of this great stuff.

Above is a chart of foreign ownership of US government debt. Notice how it has doubled over the last 8 years. In other words -- we're in debt to foreign central banks up to our eyeballs.

Treasury Secretary Paulson has continually stated that US paper is owned all over the globe. Remember -- Paulson was a big guy at Goldman Sachs. He has contacts all over the world. He knows, well, everybody. Frankly, he's one of the few appointments of the Bush administration that is qualified for his job. When he says "so and so talked to me about this" you can bet it was a conversation between people who have known each other for some time.

The point is all of the press indicates it's these conversations with foreign bankers that got Paulson's attention. That means there are some nervous people all over the globe. And that's what is driving this -- at least partially. And that should scare everyone to death. We are no longer in complete control of our sovereignty.

A long time ago (actually about three years ago) Paul Volcker wrote an editorial in the Washington Post called An Economy on Thin Ice. Consider the following as food for thought:

More recently, we've become more dependent on foreign central banks, particularly in China and Japan and elsewhere in East Asia.

It's all quite comfortable for us. We fill our shops and our garages with goods from abroad, and the competition has been a powerful restraint on our internal prices. It's surely helped keep interest rates exceptionally low despite our vanishing savings and rapid growth.

And it's comfortable for our trading partners and for those supplying the capital. Some, such as China, depend heavily on our expanding domestic markets. And for the most part, the central banks of the emerging world have been willing to hold more and more dollars, which are, after all, the closest thing the world has to a truly international currency.

The difficulty is that this seemingly comfortable pattern can't go on indefinitely. I don't know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.

I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.

This editorial seems more and more accurate as time passes.

Comments

[HawkOnTheLeft]

Bonddad -

Not only do you write great posts, you get great comments.

Fannie Mae was fine from 1938 to 1970 - while it was government owned. It was fine until until 2005, while it was a hybrid public/private. It only became not fine when we began making loans to people who couldn't pay them back - low doc, no doc, teaser rate, etc.

While most effects on Fannie were indirect, don't ignore the "American Dream Act of 2003," part of Bush's "ownership society," which required them to accept loans with only 3% down. And on regulation, it wasn't until September 2006 that the Fed, Treasury and Office of Thrift Supervision issued their joint guidance that said basically "though shalt not outsource your underwriting to anyone whose business objectives aren't the same as yours."

[ccurtis]

For years free market guys have said that the free market will just take care of itself. The arrogant idiots did not take into account that about 30% of the population is inherently selfish to a point of criminal. The bone-heads don't seem to understand that you can't run a society without rules directed at those people. That is why markets need to be regulated. When the free market dudes can make sure that responsible people, who want nothing to do with them, don't get stung by their excessively stupid money making scams then they can have their unregulated free market economy. That day will never happen because so many of them are the criminal 30%.

[racom]

ccurtis, good comment. This looming disaster, like most, can be traced back directly to the era of 'de-regulation'. When greed supersedes fiscal responsiblity we end up with another 'tax payer' bailout. Since Reagan and the free traders took over the US treasury has been like a bank with open vaults and no guards. I am sad to say the politicians from both sides the aisle have made it possible.

[jrango]

Ah... the favorite end game for american and world capitalism. Privatize the profits and socialize the risk. Let the companies hang on just long enough to let the fat cats strip all the capital/profits out and then turn the debt over to the taxayer. The real fun part is the fat cats are all based off shore so they won't have to pay back any of the debt.

The republicans told us going in (starting with that shining city on the hill guy) that their goal was to destroy the federal government's ability to serve the people at large and ultimately to destroy the government's ability to protect us from their unbridled, amoral greed. Guess what....while we where buying goods from loaner nations and amassing unsustainable debt, they built an escalator moving all the CASH to the top leaving us holding the bag. Kiss any government sponsered benefits good bye cause there ain't no money and won't be any for a long time. They won, we lost and your children will need to get use to having a lot less and your retirement will likely be one of poverty while they move to the next batch of suckers who swollow their free market, deregulation, trickle-down tripe.

Government welfare is now only for the too big to fail corporations and their finacial co-conspiritors. American workers are irrelevant, the sick, the poor the elderly are irrelevant when the american consumer becomes irrelevant its third world nation time.

[quest44]

This bail out at the tax payers expense amounts to taxation without representation.Look at the constitution and you will see any bail out by the government at the tax payers expense is illegal !

[larry278]

Whatever, illegal or not, it's how W & Co run the USA [into the ground]. W won the election in '04.

[glitz]

If more foreign investment was not available prior to the bailout....just where is "bailout" money coming from? Are we borrowing trillions more to pay for the trillions we have already borrowed? Perfect Republican financing logic.

[Svendem]

More or less. The Federal gov't is paying off private debt. Since we have a Federal budget deficit, that money will be borrowed as well, a good portion of it from foreign sources too.

It does make sense though. The Federal government still has a lot better credit rating than Fannie & Freddie right now.

[Mlinares210]

The American people have been guaranteeing Fannie Mae and Freddie Mac debt from the beginning, while investors keep the profit. If the borrower paid, the investors kept the money. If the borrower's did not pay, the government guaranteed the debt. Making Fannie and Freddie government entities stops investors from making big bucks while putting taxpayers at risk. I'm not thrilled about the taxpayers holding the bag on such a massive debt, but of all mortgage debt out there, Fannie Mae and Freddie Mac paper is the best to have around. FNMA guidelines loosened over the years, but they are still fundamentally "A Paper" loans. Freddie Mac paper is FHA and VA loans, which have fairly strict income and asset guidelines. Those people actually had to qualify based on their earnings. If anyone is going to pay their loans, these people will. Profits should be used to pay down the national debt.

[Vinca]

I just heard a caller, on C-Span, ask, how come a financial crisis always seems to happen under a republican admin, we need regulations, In my opinion we haven't had oversight on this admin or anything else

[JXJASON]

By the way,

I was AGAINST the war in Iraq. I was for less spending on the Military budget. I was against corporate lobbying. I was for higher taxes for those making over $250,000 per year. I was against free trade with China and against NAFTA.

I DID NOT VOTE FOR GEORGE BUSH. You got what you paid for in the last 8 years.

OBAMA / BIDEN 08

Get out and vote people.

As Congressman Dennis Kucinich said at the Democratic Convention " WAKE UP AMERICA "

[JXJASON]

My girlfriend, exwife, my two adult kids, and most Americans were/are too busy shopping, watching court TV, driving cars for a hobby, etc., etc, to pay any attention to articles like this one.

Too bad.

[idest]

And unfortunately they will only pay attention to articles like this one when the shopping malls close, they can't afford cable, gas is too expensive for driving as a hobby and we're so far down the slope we can't see the top anymore. It truly is a shame.

[billw8017]

The Bush deficits have been covered by the unsupported printing of money. Since prices for ordinary things were relatively inflexible, the money went up to the richest Americans. it financed all sorts of exotic financial instruments and a succession of bubbles. This is the route that the dollar chooses to decline by. The collapse of the dollar (somewhat concealed by a softer decline of other currencies) is -- quite simply -- how we pay the taxes that we didn't pay.

For thirty years, people have been making a noise about how we are piling up debts that the next generation must pay. This is absurd and everybody has regarded it with the reasonable indifference. But, as more dollars chase a limited basket of goods and despite the market for odd financial inventions prices will rise: You cannot eat today bread that is baked tomorrow and the noise about burning up the patrimony of future generations is but a legal fiction. Remember, if the debt becomes impossible, the United States can follow the example of previous empires and go into bankruptcy. What's one more bad idea when we elect so many.

[veracity]

Wow. Thanks for that, Hale. Bush-Cheney have backed the American economy to the very precipice, and the American public are being squeezed out of the last trillion dollars to provide "SOCIALIZED WELFARE BAILOUTS" to the big boys on Wall St.
Well, at least Paulson seems to be finally getting a clue, at least according to this AP article which uses words like "pragmatism", "regulation", "embolden the regulators" and above all, "abandon conservative orthodoxy."
http://www.usnews.com/blogs/flowchart/2008/7/29/paulson-a-rare-keeper.html
The AP article suggests that Treasury bailout will run at least $15 billion, and probably up to $100 billion, if it works.

But this even more rare article
http://www.huffingtonpost.com/2008/09/07/government-takes-over-fan_n_124603.html
explains that the fed & Treasury has already bailed out Wall St. bankers and brokers to the tune of $1 TRILLION dollars, long before this latest FM-FM bailout (Which Paulson pledged back in July would not be bailed out).

[Paul]

Can we just give Texas to China and call it even?

[bobwalters]

Throw in Arkansas, Mississippi and Alabama, and you might have a deal!

[RadCenter]

I thought Mexico had already retaken Texas...

[dryheaves]

they can split it ....but first we have to drive up the price ..ahh bidding war..just like the good old days....

[MikeDu]

Anyone want to take a bet that they had this bailout cooked up well ahead of time and they only waited til the Repub dog-and-pony show was well and truely done? If they hadn't waited, everyone would've been talking about America's financial collapse and not moosegirl all weekend long.

[Charley2u]

I cannot believe you give a diddley-squat about partisan politics at this moment in American history.

Jeez dude, the US just nationalized the housing market to satisfy its foreign creditors - can you say Argentina???? Can you say banana republic???

If this is not enough consider this: obligations in this bailout were originally estimated to run $25Bn, now we are seeing estimates of $300Bn-$500Bn. Having lived through Boston's Big Dig, I can tell you both these figures are way low.

Now there three sources for that cash: higher taxes (in the middle of a recession), massive spending cuts on discretionary items, or borrow even more money from China, Japan, etc. - if they will lend it to us, in addition to the billion we need everyday to offset our trade, fiscal and saving deficits.

John McCain's tax cuts - gone

Barack Obama's tax cuts - gone.

Health care plans - gone

Infrastructure investments - gone.

More money for education - gone.

Flush it all down the toilet. Flush all the silly promises by both parties.

[idest]

Of course, an even BETTER way would be to lower our defense spending to levels that at least somewhat resemble sanity. But that will never be proposed because of partisan politics.

[iambusto]

if we didnt make the Central Asian Bank bondholders whole Fannie and Freddie wouldnt be able to sell any agency paper again!! got that!!

they just might decide that they want higher interest rate on our Treasuries too. thought could increase the cost of our debt service by a few trillion $ too.

[iambusto]

if we dont make the Central Asian Bank bondholders whole Fannie and Freddie wont be able to sell any agency paper again!! got that!! they just might decide that they want higher interest rate on our Treasuries too. thought could increase the cost of our debt service by a few trillion $ too.

its that simple really !! we cant afford to piss off our asian lenders!!