Monday, September 8, 2008

Fannie, Freddie, and International Relations

. Monday, September 8, 2008

Fannie Mae and Freddie Mac, the quasi-private investment groups that own or guarantee roughly half of the U.S. mortgage market, have now effectively been nationalized. The purpose of this blog isn’t to run-down all of the domestic effects of this (for that, see Brad DeLong and Calculated Risk, and keep in mind that Fannie & Freddie own or guarantee about $6 trillion in American mortgages), but there are implications for IPE study as well.

For example, central banks, sovereign wealth funds, and other international investors bought heavily into Fannie Mae and Freddie Mac, because they were under the impression that the investments were as close to riskless as one could get*. As Treasury Secretary Paulson noted, nearly $5 trillion in Fannie/Freddie debt and securities are owned by investors all over the world. To put that into perspective, the combined GDP of the U.K. and Italy in 2007 was less than $5 trillion. There is simply no way that the U.S. Treasury could let the companies fail and allow those nations (and other investors) to take a hit that big. If they did, says Tyler Cowen, the effects would be catastrophic:

The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.

Tyler Cowen isn't known as a pessimist, but considering that “when the U.S. sneezes, the world gets a cold,” the prospects for international financial markets as a whole could have been catastrophic if the U.S. had not acted. In short, it’s likely that international political concerns, such as maintaining the credibility of the U.S. government in the eyes of other foreign nations, have essentially forced the Treasury Department to step in, even if they didn’t want to.

The news of nationalization was greeted warmly by nearly everyone. The announcement was made yesterday for the benefit of foreign financial markets trading overnight, and those markets responded by posting large gains. The heads of the European and Japanese central banks spoke positively of the take-over. There is still some pain ahead, especially for domestic banks, but by nationalizing Fannie and Freddie the U.S. Treasury may have dodged a bullet. At least temporarily.

*As it turns out, they were right: these investments were largely riskless since the implicit guarantee of the debt by the U.S. government has now turned into an explicit guarantee. Are there moral hazard concerns? You betcha. But, as the saying goes, "in the long run, we're all dead."

[UPDATE: U.S. markets posted huge gains today in response to the bail-out news. The dollar gained against the Euro, Pound, Swiss Franc, and Yen.]


Anonymous said...

China's status as #1 foreign owner of Fannie Mae and Freddie Mac securities and the fact that Americans can afford Chinese goods because countries like China take on our debt so we don't have to. NPR has a segment on this issue

One of the more interesting questions to emerge (or perhaps, reinforced by) from the Fannie/Freddie Takeover is to what extent credit markets can continue to drive growth. Since developed markets basically survive on access to cheap (or relatively cheap) credit, and Fannie and Freddie's meltdown underscore how over-extended the international credit market is, the most important question becomes to what extent can fiscal and monetary policy fix the problem and to what extent will the market need to exert painful (and quite possibly extended) corrections to the world economy.

And, then - when everything settles out - how will all this change the way the international financial system operates?

Kindred Winecoff said...

i agree. it seems the US is banking on the fact that the rest of the world has two thoughts: 1. they've got to do something with the capital account surpluses, and the US remains a low-risk place to invest relative to other countries; 2. if the US tanks, then the world economy tanks, so other countries won't exacerbate any downward movement.

the rest of the world is also banking on two facts: 1. the US government will not become insolvent, and the US government will always prevent "too big to fail" corporations from failing; 2. they might as well double-down on the US, because if the US dies then they die too.

given that, i'd expect the flow of foreign credit to the US to continue at relatively low rates for awhile. there may be a massive correction somewhere down the line, but i'd actually expect shifts in the overall system to occur in fits-and-starts. as some of the semi-Core countries boost domestic consumption, they might be able to shift resources from the US to their domestic economies. but if that happens, US exports should go up, and the whole thing will stabilize at another equilibrium.

or maybe it'll all come crashing down like a deck of cards. who can say? we're starting to see some domestic stagflation, and if the FED reverses course and goes hard after inflation then the whole dynamic shifts. if i'm in the FED (and thank God i'm not) i'm praying to the heavens that the lowering of rates in the last year pays quick dividends in terms of employment so they can shift the focus to inflation. if employment gets worse... look out.

also keep in mind: other countries own a bunch of our debt. if things get really bad, we can just deflate the debt and pass the losses off to them. they don't want that to happen, so they'll accept smaller losses today so they don't face massive losses tomorrow. keep in mind that a lot of these countries, i.e. China, have major domestic political concerns as well. everyone is strongly incentivized to keep the US markets healthy.

remember all that talk of "decoupling" from a year or so ago? haha.

Fannie, Freddie, and International Relations




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