Saturday, July 12, 2008

How will China & others react if Fannie and Freddie default on their bonds?

Chinese Government is Top Foreign Holder of Fannie Mae, Freddie Mac Bonds

"If the US bails out Fannie Mae bonds, who is the biggest beneficiary? 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. The prospectus for every GSE bond clearly states that it is not backed by the United States government. That's why investors holding agency bonds already receive a significant risk premium over Treasuries. A bailout of GSE bondholders would be perhaps the greatest taxpayer rip-off in American history. It is bad economics and you can be sure it is terrible politics."

Posted by drewster @ 06:09 PM (1203 views)
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8 thoughts on “How will China & others react if Fannie and Freddie default on their bonds?

  • Can anyone estimate the impact of a big default on the bonds? Shock waves would surely travel round the globe.

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  • There don’t seem to be many takers for Drewster’s excellent question so I’m going to have a go to try to kick off a response. I have numbered some of my comments to make it easier to criticize and to save my fingers, I’m just going to refer to both Fannie May and Freddie Mac as ‘FM’.

    Before attempting to answer Drewster’s question, here are some observations:

    1. Intially, let’s just consider the issue from a public versus private perspective and forget the nationalism i.e. imagine that a massive bank specialising in mortgages, owned by US investors with the power to issue agency bonds is in trouble.

    2. What happens if one of the FMs fails? If normal US laws are used, then either Chapter 7 or Chapter 11 bankruptcy laws will be enforced.

    3. Chapter 7 bankruptcy law deals with the liquidation of a company. Essentially, the assets are sold off to the creditors and the company is wound up.

    4. Chapter 11 bankruptcy law would permit the company to keep muddling through while trying to restructure itself to profit again under the supervision of a court.

    5. If Chapter 7 law was invoked, I presume that the the shareholders get pretty much wiped out and the agency bond holders would get miserable compensation. It is hard to see how anybody would be willing to buy FM agency bonds any more which would place the remaining FM under terrible pressure. It would also be very hard to get a mortgage in the US leading to absolute armageddon for US house prices and all the associated fallout (oh sorry I forgot, we’re already going there).

    6. I am unsure how chapter 11 bankruptcy would work in practice. I think it’s worth noting that the demand for FM agency bonds thereafter would disappear considering how much safer T bonds are – the only reason that investor buy agency bonds is that they yield a higher return but are not guaranteed by the government.

    7. My best guess, therefore, is that some arrangement resembling a chapter 11 bankruptucy would be used because the government would not want to see their mortgage market destroyed hence they could not afford to discourage investors. Perhaps the government could offer to buy agency bonds at a discounted rate using T bonds? This would convert the bonds into something safer for investors at a price to the US taxpayer but at a discount that might cushion the blow a bit.

    8. Now returning to the nationalist question, the pressure on the US government to appease foreign investors appears to be even greater to me. My point is that the US relies totally upon foreigners accepting US debt to finance itself hence the government will probably be even more scared of offending China et al. than US investors.

    Now I’ll return to Drewster’s question. Because of the observations I have made above, I think that demand for FM bonds by any investors, including foreign ones, would disappear if FM defaulted after which the US mortgage market would freeze. It would be so hard to get a mortgage in the US that the their housing market would collapse (further). That’s also why I think it won’t happen. Instead, the US taxpayer will be made to pay.

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  • I am pretty certain that China’s immense holding of dollar securities is a strategic tactic, aimed at getting the Yanks over a barrel. The Chinese seem to distrust the Americans, and probably reason that dealing from a position of strength is prudent.

    With their currency destined to steadily rise against the dollar, it makes no sense to hold these assets purely as an investment.

    A default would not mean that the investers lost everything – far from it. However, if Washington is not seen to make some effort to minimise the fallout from the problem, China might deliberately upset the bond market with some sudden sell-offs, to put a shot across their bows..

    Even without a deliberate act on the part of the Chinese, there is a serious risk of a run on Treasuries and Gilts; and it would take little more than a rumour that the Chinese had started selling to kick one off, which in turn would force the Fed and BOE to raise interest rates – possibly severely.

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  • @uncle tom

    “it would take little more than a rumour that the Chinese had started selling to kick one off, which in turn would force the Fed and BOE to raise interest rates – possibly severely.”

    I would be happy for our interest rates to rise. Strange – I never really expected to see my personal concerns aligned with the actions of the Chinese government.

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  • Beenseendone says:

    You have missed the more interesting numbers, from a UK perspective. Across to corporate debt – look at the amount of debt held by the UK. What happens to the UK if this stuff starts defaluting?

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  • I fight very shy of conspiracy theories generally, but there were decades where the west was set against the east, as Russia and China, even given it’s coy and pragmatic sublimation to middle east regimes, many of whom are idealogically hostile to the west.
    Now it seems these same nations are well positioned to manipulate the west and to tease and, if they feel like it, completely undemine the US and Europe. is this a paranoid view? Or is there a coordinated effort, even unintentional but recognised and not restrained, taking place?
    It seems to me that if one wanted to take the west down, hiking oil and commodity prices at a time like this would be a good way to do it. Together with the Iranian thing. The storm seems so perfect that it might almost be contrived, or at least encouraged. Even if the whole thing simply appeared by accident rather than intent, there seems to be little response from ‘the other side’ to ameliorating this crisis. Instead everyone seems to be looking on in gleeful fascination as the west spins out of control, particularly the nemesis of many – the US. It all just seems a little convenient and coincidental. Although as I say, I don’t really belive that such a thing is happening…I still have this slightly uneasy feeling though.

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  • jamonit,

    Knowing China very well, having been there on business some forty times over the last fifteen years, I don’t believe that China wants to be hostile to the west, but they do want to be taken seriously as a nation, and shown a little more respect.

    The west, and the US in particular, has a bad habit of talking down to the Chinese – something the Chinese people find deeply offensive.

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  • Chinese Person says:

    The implied idea that China wants the US to go down is completely absurd. Sure, China does not trust the US due to its history with double standards and military aggression against the weaker nations. Beyond that, why *should* China trust the US at this point when the government-sponsored Fannie and Freddie are at the risk of defaulting and never paying back. That is 10% of China’s GDP. It is outrageous to think that China *wants* the US economy to collapse. Geez, at least pay us back the money you owe us before you go down.

    Note that China isn’t North Korea and it isn’t about shaking the whole world for attention. There is a reason why millions of Chinese people are rising above poverty every year. It is doing a fine job at managing its economy.

    Another thing to note is, in contrast to the above commentators, no one *wants* to hike the oil and commodity prices. Before Americans rage on about their 4 dollars per gallon, China has been experiencing double-digit inflation for a few years! There is a food crisis in Africa for chrissake! Please get it into yourself that no one out there is trying to get America (at least not via economic speculations).

    So *how* did this happen? Thanks to the derivative markets who turn nothing into profits. Blame the derivative traders. Blame the big investment bankers who bank millions and millions of dollars home. Blame the Americans who buy houses they can’t afford. Blame the Americans who mortgage their houses for a brand new hummer that consume more gas than five Japanese cars combined.

    In conclusion, the root of the problem is the fact that Americans overspend. They buy things they can’t afford, declare bankruptcy and stop paying for their mortgages. The US government started a war they can’t pay for, pass spending bills with money that they don’t have and now is bringing the whole world down with them.

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