Tuesday, September 9, 2008

Foreign Investors a Key Driver Of Freddie and Fannie Deal

From the WSJ:

Foreign central banks had been among those voicing concerns in the weeks ahead of the government's seizure of Freddie and Fannie. The banks had steadily reduced their holdings of debt in the two firms in recent weeks as the turmoil around the firms worsened.

China's four biggest commercial banks, too, pared back their holdings in agency debt, with Bank of China Ltd., the largest holder of Fannie and Freddie securities among these banks, saying it sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30, down from more than $20 billion at the end of last year.

Treasury tried to head off such concerns by having David McCormick, an assistant secretary for international affairs, call foreign central banks and other overseas buyers of the companies' securities or debt to reassure them of the instruments' creditworthiness. Over the weekend, Treasury officials called sovereign-wealth funds in Abu Dhabi and elsewhere in the Middle East, assuring them that they were working on financial issues involving Fannie and Freddie, says an individual apprised of the conversations.

Like many investors, foreign governments, particularly central banks and sovereign-wealth funds, believed the U.S. government implicitly stood behind Fannie and Freddie and would prop them up to prevent a failure.

But when the Treasury won approval from Congress in July to backstop the pair through an equity investment or a loan, it sparked questions among some investors about the relationship between the government and the mortgage giants.

Amid worries about the debts' backing by the U.S. government, some central banks decided to buy Treasury securities instead. That increased the spread between the rates for Treasuries and mortgages, exacerbating the crisis that officials had been trying to resolve.

In his public comments Sunday, Mr. Paulson said the "ambiguities" in the firms' congressional charters led foreign central banks and investors in the U.S. and around the world to believe the firms' debt was "virtually risk-free."

"Because the U.S. government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings," Mr. Paulson said.

On Monday, Mr. Paulson sought to assuage the concerns of foreign officials, explaining the government's takeover in a brief call with his financial counterparts in the Group of Seven.

A few points here:

1.) Paulson -- for all that I have criticized and even lampooned him -- is the right man for this job. He has extensive experience in dealing with big deals and big name players. He probably knows most of these people in a more than passing way in one capacity or another.

2.) The next Congress has to put aside partisan differences and hold extensive hearings on the entire financial system. We need to look at all the pieces, big and small, and figure out what needs to be done to provide competitive financing and prevent the last 7 years from happening again. The chance of that happening is, well, 0%.

3.) Perhaps the biggest crime with this situation is the reason for it -- the fact the US' trade deficit and lack of domestic savings leads to the need for foreign financing -- is so incredibly ephemeral that explaining it to most people is at best incredibly difficult. If there was a straight-forward reason for this happening it would be so much easier to deal with and solve. But trade deficits and foreign financing just seem so beyond the experience or exotic to most people that solving the underlying problem is next to impossible.

4.) Yesterday I wrote the following:

The point is all of the press indicates it's these conversations with foreign bankers that got Paulson's attention. That means there are some nervous people all over the globe. And that's what is driving this -- at least partially. And that should scare everyone to death. We are no longer in complete control of our sovereignty.

Think about this for a minute. One of the largest financial decisions of the last 100 years -- the decision to essentially nationalize elements of the mortgage market -- was driven by outside (non-US) investors. That does not mean we should stop selling our assets to non-US investors -- they are, after all, a vital source of funding for a variety of projects etc.... However, it is important to note that things are not going well in the US. That means that foreign investors who want to protect their investments will speak up and talk too the appropriate people in the US.

Throughout my writing career I have written extensively about debt. Right now the US is in debt up to its eyeballs. The federal government has issued over $500 billion dollars of net new debt per year since 2003. That means there is a fundamental problem in the US budgeting process that no one is addressing. The US consumer is just as bad. According to the federal reserve's flow of funds report, there is almost as much household debt as there is US GDP.

All of this debt has to go somewhere. That means that when we borrow money someone inherently has to lend it. And a fundamental rule of lenders is this: they want to be repaid. We've now seen the first round of lenders saying, "we want too make sure we will get repaid." Right now we have no idea how much this is going to cost, although I have a terrible feeling it's going to be far more than anyone is estimating.

But the real issue is our method of doing business as a country has finally gotten us in trouble. That means all of the people we have borrowed money from got nervous for the first time and said, "you better do something or we won't lend you money any more." And to keep the spigots pouring, we nationalized Freddie and Fannie.

Think about this basic fact: we -- the US as expressed through the Congress -- were not the people who decided what to do. Foreign investors forced out hand and made us allocate up to $200 billion to this endeavor.

Out way of doing business is broken.