Fannie Mae and Freddie Mac: A Broader View

At the cost of tens of billions to the American taxpayer, the U.S. government will bailout Fannie Mae and Freddie Mac, both private companies created by Congress. Back in March,

Because of the widespread perception that the government would intervene if either company failed, they can borrow money at lower interest rates than their competitors. As a result, they have earned enormous profits that have enriched shareholders and managers alike: from 1990 to 2000, each company’s stock grew more than 500 percent and top executives were paid tens of millions of dollars.
…In a March meeting, Freddie Mac’s chairman, Richard F. Syron, bolstered those fears by saying the company would put shareholders’ interests first.

What is the nature of the bailout, whose investment is protected and whose investment is not?

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.”

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 collapse of Fannie and Freddie is being heard around the world. Although both presidential candidates may not be giving it the real attention it deserves, both have heard the collapse.

Sen. John McCain, the Republican nominee for president, has said his goal is to make the companies “go away” and to push for regulation that “limits their ability to borrow, shrinks their size until they are no longer a threat to our economy and privatizes and eliminates their links to the government.” Sen. McCain supported giving Treasury the authority to backstop the firms but has said any use of taxpayer funds should be combined with an ouster of management and a ban on lobbying by the companies.

Sen. Barack Obama, the Democratic nominee, has said the companies are a “weird blend” and that “if these are public entities, then they’ve got to get out of the profit-making business, and if they’re private entities, then we don’t bail them out.”

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.

As far as I can see, neither candidate is willing to tell us frankly just how dire our difficulties are–and to whom we owe money. We have off-shored much of our manufacturing sector in the name of efficiency and profits, ignored our energy needs, and allowed our financial institutions to rape and pillage the countryside. Some have grumbled and tightened their belts; others have smiled and fattened their wallets; yet others have just watched and written studies on entrepreneurial innovation.

Regardless of who wins the upcoming election, the next president will faced enormous problems and a lot of anger…and not much in the way of solutions.

Right now, there are no easy answers.