Saving the People’s Bank of China

Who the Fannie Mae/Freddie Mac bailout is really supposed to help.

Read more about Wall Street’s ongoing crisis.

Henry Paulson

On Sunday, the Treasury Department announced that it would effectively take over Fannie Mae and Freddie Mac, the critically wounded government-sponsored mortgage behemoths. (This landing page at the Treasury Department has the details.)

Generally speaking, the federal government has been content merely to watch the failures stemming from the real-estate/housing-credit bubble. If individuals default on their mortgages and get foreclosed on, that’s their proper comeuppance. If subprime lenders go out of business, that’s capitalism’s creative destruction. If banks start to fail, as they’re now doing at a rate of one per week, no big deal.

But Washington reacted with alacrity when a second-tier investment bank, Bear Stearns, threatened to take the plunge. And the case of Fannie Mae and Freddie Mac is a rare example of Washington regulators being slightly ahead of the curve. Of course, Fannie and Freddie are bigger and more significant than any of the financial firms that have failed thus far. But the reason for the fevered weekend rescue activity has less to do with the companies’ size than with their scope.

When U.S.-based banks fail, the outcomes are pretty unpleasant. Still, there’s a tried-and-true mechanism in place to deal with them: the FDIC. The damage—closed branches; job losses; angry shareholders, lenders, and depositors—is real, but it is generally contained to the geographical areas in which the bank operates. But with Fannie Mae and Freddie Mac, and to a lesser degree with Bear Stearns, it’s more like an airborne virus than a localized explosion. They had the capacity to inflict huge damage around the globe and to cripple the international financial system. And for that reason, they couldn’t be allowed to go down. In the case of Bear Stearns, the potential victims were counterparties to trades all around the world. In the case of Fannie Mae and Freddie Mac, the potential victims were central banks and foreign institutions that have bought their debt by the boatload. It’s no accident that the takeover was announced in the middle of the day on Sunday. (Barry Ritholtz chronicles a slew of other recent Sunday credit-related announcements.) It was timed to get out before the Asian markets opened for trading on Monday.

For years, as scolds warned of the dangers of a low U.S. savings rate and a massive trade deficit, optimists pointed out the bright side. Chinese central banks and Persian Gulf petrogovernments take the dollars we send them for oil and manufactured goods and spend them on dollar-denominated assets such as Treasury bonds, thus financing our consumption and keeping interest rates low. For foreigners, Treasury bonds have long been the safest best. But as the Federal Reserve slashed interest rates a few years ago, Treasuries became less attractive. And the foreigners began to gobble up the type of debt issued by “government-sponsored enterprises” Fannie Mae and Freddie Mac. With their implicit guarantee, the GSEs were deemed to be just as safe as U.S. government bonds but paid a slightly higher interest rate. The Federal Reserve quarterly flow of funds accounts tells the story. As chart L107 shows, in 2003, non-U.S. investors held $654.8 billion of agency or government-sponsored enterprise debt. That was divided among official investors like central banks ($262.9 billion) and private investors ($391.8 billion). That year, official foreign authorities thus held about 8 percent of the total agency/GSE debt. With every passing year, the amount of debt held by foreigners—and especially by official foreign investors—rose dramatically. In the first quarter of 2008, foreigners held $1.54 trillion in such debt. But now, official authorities hold most of that total ($985 billion). In five years, then, official authorities more than tripled their holdings. And as of the first quarter of 2008, they held 21.4 percent of the total.

When foreigners buy bonds denominated in dollars, they assume three related risks: currency risk (if the dollar weakens, then dollar-denominated assets fall in value); interest-rate risk (if interest rates rise, the value of fixed-income investments falls); and repayment risks (the value of bonds can fall if doubts arise over whether the debt will be paid back). The foreign investors that loaded up on Fannie and Freddie debt assumed the first two risks but didn’t bargain for the third. And as doubts about the viability of Fannie and Freddie grew, foreign central banks suddenly found themselves massively exposed. With the agencies needing to sell billions of dollars of debt on a weekly basis, and with the U.S. institutions lacking capital, proper deference had to be paid to the foreigners. The U.S. government had to protect their GSE investments. Paulson & Co. face an extra burden because foreign investors have been so badly burned by the U.S. financial sector. When sovereign wealth funds began buying chunks of Wall Street firms after they had imploded, Paulson repeatedly trumpeted those purchases as international votes of confidence. But those investments have been disastrous for the foreign purchases, as Asian and Persian Gulf authorities have lost billons on the Blackstone Group, Citigroup, Merrill Lynch, and others investments.

The bailout of Fannie Mae and Freddie Mac will be sold and marketed as an effort to shore up the U.S. housing market. Maybe so. But it is mostly meant to shore up our damaged international financial standing, preserving leadership and making sure the U.S. Treasury Secretary doesn’t get tarred and feathered at the next G-8 meeting.