Fannie and Freddie: The politics of finance

By Edward Harrison On Sep 9, 2008

The post-mortems on Fannie and Freddie are flying in. It seems like it is almost non-stop Fannie and Freddie. Let me add to those voices with a bit of a twist: the bailout of Fannie and Freddie was as much a political move as it was a move to save financial markets.

While I see the Fannie-Freddie bailout as flawed, I tend to agree with the likes of Warren Buffett, who said:

It’s the best deal, and the most sensible deal available now. You can argue that there should have been some different rules put in decades ago in terms of what these companies have done, and it wouldn’t have come to this, but those rules weren’t put in by this Administration, or this Congress or this Treasury Secretary, and they face the problem of, in effect, five trillion plus of a combination of portfolio and insurance out there, and, really, chaos in the housing and mortgage markets. So, I would have made exactly, I would have, insisted on something like that, really 80 percent interest at a nominal price to get in there in case the common did have value at some point. And I would have insisted on the priority of common over preferred. I think they made the right deal. It may cost them some money, but it’s going to cost a lot less than anything else they would have done.
–CNBC interview, 8 September 2008

The long and short of the bailout is: you can quibble over details all you want because no bailout is going to satisfy everyone. But, the fact remains that Fannie and Freddie were effectively insolvent and the longer the government waited to act, the worse things were going to get, the more losses we would have had, and the larger the chance of systemic meltdown in the financial sector.

But, more than that, I would argue the bailout is a political construct, first and foremost. On Friday, I enumerated a whole host of reasons that the bailout needed to happen, most of them political. Here are some of the considerations to keep in mind:

The Chinese, Japanese and other foreign governments are major holders of GSE debt. These governments bought Fannie and Freddie believing them to be equivalent to U.S. government bonds. The Chinese Central Bank is now struggling with capital inadequacy due to the losses they had booked on their GSE investments.
Now, we can argue that GSE debt holders deserve to take a ‘haircut’ (small loss on their investment) or converted into equity as Bill Ackman advised in order to right the ship equitably.

But the reality is that the United States, for political reasons, does not under any circumstances want foreign governments to think that the U.S. has defaulted or even partially defaulted on its debt — which is what a haircut or equity conversion is tantamount to. This would be unacceptable and would have severely negative consequences for U.S. markets where foreigners are supplying most of the savings to fund the U.S. current account and government deficit.

Mutual Funds considered GSE paper to be government bonds too. Go to any mutual fund site, say Vanguard, and you will see that their government bond funds are loaded with debt from Fannie and Freddie (I know because I liquidated all of my government bond fund positions there in February for that reason). Again one could argue that these fund managers should have known better. But, the political reality is they did not and it would be a brave politician who would ‘expropriate’ their investment by converting it into equity or taking a haircut.

Bill Gross, the manager of America’s largest Bond fund has recently been loading up on GSE paper. He has also been calling agressively for the U.S. Government to do something to stop the asset meltdown in the US, obviously with more than a little self-interest. His voice represents a group of money managers with a lot of political clout. The same political arguments as above hold in not ‘expropriating’ his investment.

Owning Fannie and Freddie makes controlling the housing market easier. I have had a sneaking suspicion for quite some time that Fannie and Freddie would be nationalized, in part to control the housing market. At present they represent 70% of new issuances in the Mortgage-backed securities market, where their pre-crisis historical share was only 50%. They are effectively the only game in town and without them, mortgage interest rates in the U.S. would be a lot higher.
With Fannie and Freddie under government control — and with an explicit government guarantee, it will make it a lot easier to keep mortgage rates low and to supply liquidity to the housing market. The U.S. government obviously hopes to prop up housing prices this way. And remember, residential property is Americans’ largest financial asset. With an election in two months, any politician knows that a falling housing market is not good for re-election.

Conclusion?
Before getting into specifics, I want to highlight a quote made by a former Chinese central banker.

“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.”
–Quote of the day: 27 Aug 2008, Credit Writedowns

What one must realize is that the United States is a debtor nation — the largest debtor nation in history. Without the Chinese, the Japanese and the Middle East and their money, things would be much worse in the U.S. The Bush Administration knows this. Hank Paulson knows this. And judging from the previous quote, the Chinese know this too.

A large part of why the United States is not suffering more has to do with foreign governments buying debt issued by Fannie Mae and Freddie Mac under the assumption that it was as good as buying U.S. treasurys — with the upside of an extra 30 or 40 basis points. Therefore, for just that reason, Hank Paulson has protected these debt holders against losses and converted Fannie and Freddie debt into U.S. taxpayer debt.

To do otherwise would be seen by China and other foreign governments as an effective default by the U.S. government. And that just won’t do. Ask Argentina.

Sources
Gross Expects Benefits From Fannie, Freddie Takeover – Bloomberg Video

Warren Buffett Tells CNBC Treasury “Did Exactly the Right Thing” on Fannie/Freddie – CNBC