Sunday, Bloody Sunday

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 all the details.

What gives? Generally speaking, the federal government has been content to watch the cascade of failures stemming from the late real estate/housing-credit bubble. If individuals default on their mortgages and get foreclosed on, that's the proper comeuppance for speculators and people who put no money down. If subprime lenders go out of business and the world's largest lender falters, that's creative destruction. If banks start to fail, as they're now doing at a rate of once per week, no big deal.

But Washington reacted with much greater alacrity when a second-tier investment bank like 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 activity has less to do with the companies' size than with their scope.

When U.S.-based banks fail, the outcomes are bad. But 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 some depositors—is real, but it is generally contained to the geographic areas in which the bank operates. With Fannie Mae and Freddie Mac, and to a lesser degree with Bear, Stearns, however, the situation is more aptly compared to an airborne virus than to a localized explosion. They have the real capacity to inflict real damage throughout 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 move was announced in the middle of the day on Sunday. (Barry Ritholtz chronicles a slew of other recent Sunday credit-related announcements.) It's not because U.S. policymakers hope the news would be buried as American portfolio managers watched football games. Rather, announcements like this are timed to get out before the Asian markets open 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 monetary authorities take the dollars we send them for oil and manufactured goods and spend them on dollar-denominated assets like Treasury bonds, thus financing our consumption and keeping interest rates low. For foreigners, Treasury bonds were the safest best. But in the middle years of this century, as the Federal Reserve slashed interest rates, Treasuries became less attractive. And the foreigners began to gobble up the type of debt that government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac issued. 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 between 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. Treasury Secretary Hank Paulson & Co. face an extra burden—appeasing foreign investors—because they've 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 them as international votes of confidence. But this capital has received shoddy treatment on our shores: the purchases of stock by Asian and Persian Gulf authorities in the Blackstone Group, Citigroup, Merrill, Lynch and others have all been massive losers.

The bailout of Fannie Mae and Freddie Mac will be sold and marketed as efforts to shore up the U.S. housing market. That could be. But they are really meant at shoring 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. In a world of significant global financial imbalances, the doctrine of "too big to fail," has been replaced by the doctrine of "too international to fail."

© 2008