Wed, September 10, 2008
On the Inevitability of the Fannie-Freddie Bailout
As the graph below from BlogPulse.com shows, the announcement of the Fannie-Freddie takeover generated a burst of activity in the blogosphere.
In perusing some of the posts on the topic, it looks as though a lot of people are upset at what appears to them to be a bailout. In fact, it is a bailout, but at this point in the game, I think the U.S. Treasury really had very little choice.
As a nation, we love debt. Fortunately, we have neighbors, like Japan, China, United Kingdom, and Brazil, who are willing to lend us money. For example, as of this past June, foreign holdings of U.S. Treasury securities stood at $2.6 trillion. They do this because (a) they are better savers than we are, and (b) they consider our nation to be a good credit risk.
Similarly, foreign investors are estimated to hold more than $1.4 trillion in the debt securities of US agencies like Fannie Mae and Freddie Mac. A good chunk of these bonds are held by the central banks of several nations. The debt was purchased with the understanding that the agencies had an “implied” guarantee from the US government. Now, as Evan Newmark of the Wall Street Journal’s Mean Streets blog pointed out in July, the idea of an implicit guarantee is sort of Jedi mind trick – how do you have a guarantee if it’s not explicit? The federal government has implied for a long time that it stood behind Fannie and Freddie without actually defining what that meant, hoping that the guarantee would never be tested. The existence of companies like Fannie Mae and Freddie Mac made it possible for the American mortgage market to function and flourish, and that seemed like a good arrangement to most people until the wheels fell off the mortgage financing bus.
Fannie Mae and Freddie Mac were apparently approaching the point of a default. That would’ve been a very nasty problem for the whole country if the government had not stepped in to fulfil its implied guarantee. The defaults would have hit debt owned by countries that have been bankrolling our national borrowing for some time. They would have been pretty unhappy, to say the least, but that wouldn’t be the worst of the problem. Beyond the fact that their willingness to lend us money in the future would have been severely impaired, the countries would have faced financial crises of their own. The world is a very small place when it comes to financial markets, and a Fannie or Freddie debt default could have triggered a world-wide financial crisis.
Now, one question that might arise is, why didn’t the Treasury also bail out stock holders of Fannie Mae and Freddie Mac? Their stocks have dropped fivefold as a result of the plan. But stockholders are always last in line if a company goes bankrupt, and the stock holders had plenty of warning that things were not looking good for Fannie and Freddie. The ones who scooped up the stock were counting on a sweet deal from the government that never materialized. Besides, the total stock capitalization of the two companies prior to the conservatorship was about $7.5 billion. That’s not hay, but trashing the stock just doesn’t have the same size consequences for the financial markets. Bond defaults, however, are a big deal, not only because of the amount of money directly involved but because there are other borrowings that were made under the assumption that the bonds would pay out on reliable terms.
Mortgage markets have responded to the news of the bailout with lower rates. Rates could stay lower for a little while, so this could be a good time to refinance or borrow if you can find a lender willing to make a loan. But in the longer term, interest rates could rise again as the markets digest the fact that the US government may take on a lot more debt in rescuing Fannie Mae and Freddie Mac. As David Merkel noted out a couple of days ago, there will come a point when the government won’t be able to keep taking on more debt. Eventually, the foreign nations bankrolling us will demand more interest than we can afford.
Addendum, 2008-09-11 - I should also have noted that among Fannie and Freddie’s other obligations are guarantees on $3.7 trillion in mortgage-backed securities. As Business Week Economics editor Peter Coy noted yesterday, “Those securities are held by risk-averse investors such as banks, pension funds, and central banks around the world. Asian central bankers, in particular, had pressed the Treasury Dept. for action in the weeks before the takeover. Technically, Treasury is not guaranteeing the twins’ obligations, but the chance that it would tolerate a default has dropped from small to near zero.”
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