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**zoog** · September 10, 2008, 04:03 PM

Re: iTulip.com One Minute Commentary: Fannie/Freddie Bailout

LOL that's a good one.:p

**Guest** · September 11, 2008, 05:02 PM

Re: iTulip.com One Minute Commentary: Fannie/Freddie Bailout

Funny clip. But did they have a choice? What exactly would be the scenario if they didn't do this? I'd like to hear how it would have played out. What would be the effect on the average citizen?

**metalman** · September 11, 2008, 05:21 PM

Re: iTulip.com One Minute Commentary: Fannie/Freddie Bailout

Originally posted by brucec42 View Post

Funny clip. But did they have a choice? What exactly would be the scenario if they didn't do this? I'd like to hear how it would have played out. What would be the effect on the average citizen?

bruce, from Politics of Foreign Debt - Part I: Why the government had to bail out the GSEs...

To make a long story short, the practice of keeping foreign holdings of US agency and treasury debt on Fed account started under Arthur Burns in the early 1970s as a way for the US to regain control of its currency that the US was losing to the euro dollar market.

Banking expert Martin Mayer, author of The Bankers: The Next Generation The New Worlds Money Credit Banking Electronic Age

and a dozen other books on banking and frequent writer for Barron�s Magazine, Institutional Investor, and others explains:

Exporters to America who keep the dollars and use them for American purchases and investments create what economists call an autonomous flow of funds back to the United States, financing the American trade deficit with an American investment surplus.

This produces the argument most closely associated with the new Federal Reserve chairman, Ben Bernanke (though Alan Greenspan believed it, too), that our trade deficit is caused by a surplus of savings that can't be profitably invested in the home countries of our trading partners. Financing for our trade deficit comes before � and actually causes � the deficit itself.

If instead of investing their dollars in the United States, foreign exporters want to take the proceeds of their sales in their own currency, their central banks will in effect sell them that currency for their dollars. Back in the late 1960's, when Great Society deficits and the Vietnam War prompted the first serious sell-off of dollars (and forced the United States to abandon the gold standard because too many holders of dollars, led by President Charles de Gaulle of France, wanted gold), those central banks lent those dollars into the new Eurodollar market, where they traded somewhat separately from domestic dollars.

This created a nightmarish prospect of the United States losing control of its own currency, and in 1971 the Fed chairman, Arthur Burns, negotiated a deal with the European and Japanese central banks. The deal was that they would return to America the dollars they acquired in their own economies, and the Fed would invest the money on their behalf, in absolutely safe government securities, without charge and at the best rates.

Today, the Fed continues as custodian of the "foreign official holdings" of such government obligations. During the Clinton administration, the Fed agreed to invest in federally guaranteed housing securities for those foreign central banks that wanted a better yield on their dollar reserves than they would get from government bonds, and now half a trillion dollars* of the total official holdings are invested in agency paper.

Foreign official holdings of government paper is a miner's canary number. It tells you if there is big trouble ahead. The most common worry is that the number will shrink suddenly, with foreign governments dumping their dollar holdings, driving down the dollar's value and driving up American interest rates, but that's not a real danger. If the price of our government securities dived, the foreign central banks would have to bear the loss. This would be a budget item for their governments, whose leaders would not like it at all.

- Federal Reserve System: The Mark of the Bust, Martin Mayer, June 14, 2006

* Half a trillion two years ago, almost a trillion today.

In 1999 we developed a theory of asset bubble inflations, crashes, and government economic reflation that forecasts the process as ultimately inflationary: Ka-Poom Theory. The theory holds that at the end of one of the bubble cycles that started in the late 1980s, foreign investors sell US debt, the dollar falls, and an inflation cycle begins driven by rising import prices, leading to economic contraction, further loss of confidence in the US economy and foreign sales of US debt and repatriation of dollars, creating a whirlpool of inflation and economic contraction.

The �Poom� portion of the cycle did not occur after the 2000 technology stock bust for reasons that, while profound, were unforeseen by us and passed largely unnoticed in the business press. When it occurred in 2003, alarm bells should have rung from sea to shining sea: private money exited the market and government money filled in the gap.

Foreign central banks rushed in starting in 2003 where private investors
feared to tread after the technology stock bubble collapsed in 2000

In 1998 foreign private and official holdings of US Treasury debt by foreign central banks were about equal, at 51% and 49% respectively. But after the technology stock bubble and bust, private investors lost faith in the US economy and markets. To prevent a destructive self-reinforcing cycle of rising interest rates and economic contraction if foreign flows were allowed to reverse, starting in 2003 foreign central banks purchased treasuries at a higher rate to compensate for the decline in private foreign investment until by Q1 2008 the ratio stood at 61% official holdings to 39% private.

This marked the beginning of a period of political versus economic investment by foreign governments in the US. One government does not support another without purpose; compensation is expected in return, which compensation may not accord with US domestic interests. The bailout of Fannie and Freddie is the first example of a domestic economic policy decision made to satisfy short term foreign and US interests to the detriment of long term US interests. As we circle the whirlpool created by foreign debt and the folly of the FIRE Economy that the debt has enabled, you can be certain it will not be the last. To make matters worse, the maintenance of the FIRE Economy depends on foreign lending from non-market oriented, unelected often repressive governments. More on that and the implications later.

In 2006, when Treasuries get too expensive, the US sells agency debt instead

After the tech bubble burst, treasury bond yields fell below 5%

After the bursting of the technology bubble and private foreign investors left the US Treasury market to investment by foreign lenders, Treasury bond yields dropped below 5%, the lowest rate in decades. Both foreign private and government investors sought US debt that earned more interest. The Treasury had a solution: buy more debt issued by GSEs known as agency debt, especially Fannie Mae and Freddie Mac whose bonds were earning over 6%. While not explicitly guaranteed by the US government, an implicit US government guarantee of agency debt is widely perceived in the marketplace.

Agency debt carries an implicit US government guarantee and pays a
higher rate of interest than US treasuries

Foreign private and official investors began to pile into agency debt after the end of the last recession, A in the chart below, that followed the technology stock bubble bust because the yield was better than Treasury bonds but with perceived similar default risk due to an implicit government guarantee. In 2006, B in the chart below, as the housing bubble started to peter out once again private investors pulled back from US markets and foreign central banks took up the slack, just as they had by buying treasury bonds following the technology stock bubble bust in 2003.

First arrow A shows an increase in agency debt purchases by foreign investors
starting around the last recession in 2001. Central banks picked up
where private investors left off in 2006, as shown by second arrow B

In 1994, private foreign investment in US agency debt was more than 11 times the level of investment by foreign central banks. By 2002, central banks stepped up their purchases in search of higher yields than Treasury bonds offered and private investors shunned the US post-bubble economy; the proportion of private foreign investment fell to a level not quite twice the level of the central banks. As of Q1 2008 foreign central bank agency liability increased 442% to $984 billion from $181 billion in 2002. Foreign central banks now hold almost twice as many agency bonds as private holders.

For the first time in history, the US government is now beholden to foreign governments for the bulk of the treasury debt used to finance its government and the bedrock of its financial system, and also agency debt, the foundation of its housing market, the crown jewel of the FIRE Economy. Here�s the total foreign debt picture since 2001 from a 2007 presentation by the Congressional Budget Office.

If the US did not act quickly to make the implicit guarantee of GSE credit explicit for $984 billion in foreign central bank liabilities, agency debt would have sold off and mortgage rates would have spiked. We estimate that the potential increase in agency bond yields and mortgage rates as similar to or greater than occurred in 1994 when 30 year mortgage rates increased from 6.75% to 9.25%

The 30 year fixed mortgage rate is vulnerable to an increase from the current 6.43% rate to over 10% in 2008 if foreign central banks lower their exposure to Fannie and Freddie bonds because the US government failed to bail. With the US housing market already in tatters, such an increase in mortgage rates would steer the US economy into the whirlpool of credit contraction, economic contraction, currency depreciation, and inflation � the bane of all nations in history that have developed external debts beyond their means to repay.