and are too big to fail.
The U.S. Treasury and the Federal Reserve recognize that taxpayers will have to pay whatever it takes to keep these two players in the mortgage game. With $5 trillion in financial paper in the markets tied to these two companies, a failure at one or the other would panic the U.S. and every other financial market in the world.
We wouldn't have to wonder about whether the U.S. economy would slip into a recession because we'd be in one -- and looking a depression straight in the eye.
Fannie Mae and Freddie Mac are also just plain too big. It's incredible that two companies could be so large that their troubles could threaten the U.S. and global economies.
Creditworthiness of the country at stakeIt's their very size that has turned the current financial crisis into something affecting much more than the mortgage market or even the U.S. banking sector. What's at stake now is the credit of the United States itself.
Because of Fannie Mae and Freddie Mac, the overseas investors who hold $9 trillion in U.S. government debt and trillions more in U.S. dollars are weeks away from losing faith in the government's creditworthiness.
In the days since the crisis at Fannie and Freddie turned red-hot, the council that advises Saudi Arabia's king has recommended revaluing the Saudi currency, the riyal, which is pegged to the U.S. dollar, by up to 30%. That could be a first step toward switching the riyal from a price pegged to the dollar to one pegged to a basket of world currencies.
A similar advisory body in Abu Dhabi has suggested abandoning that country's dollar peg for its currency. A third oil-rich Middle Eastern country, Kuwait, ended its currency link to the dollar last year.
More ominously, because the threat is more immediate, some of the world's largest sovereign wealth funds, including that of China, are edging away from the U.S. dollar at an increasing speed. China's State Administration of Foreign Exchange, which holds the majority of China's $1.6 trillion in foreign currency reserves (mostly in dollars), has been holding talks with European private-equity companies about investing in their latest round of funds. That would shift dollars into euros.
Why Fannie and Freddie matter overseasSo why is the crisis at Fannie Mae and Freddie Mac so important to overseas investors? Three reasons:
- Size counts. The two companies own or guarantee $5 trillion in home mortgages. That's a little less than half of the $12 trillion U.S. mortgage market. In comparison, the total U.S. government public debt totals just $9.5 trillion. (In addition, Fannie Mae and Freddie Mac have $831 billion and $644 billion. respectively, in bonds outstanding.)
- The companies have behaved like part of the U.S. government. Despite a clear statement to the contrary in the legislation that set up Fannie Mae and Freddie Mac, most investors believe the U.S. government stands behind the two companies. This belief in some sort of implicit "guarantee" is the major reason that Fannie Mae and Freddie Mac have long been able to borrow money in the financial markets at a lower rate of interest than other mortgage lenders. The edge created by the belief in an implicit guarantee has been a key to the two companies' ability to grab an ever bigger share of the mortgage market. The management teams at Fannie Mae and Freddie Mac have behaved as if they believed in that implicit guarantee, too. They used their access to cheap money to build up huge mortgage positions without raising much actual capital from investors. The $5 trillion in owned or guaranteed mortgages at the two companies is backed by less than $100 billion in actual capital. That's leverage of 50-to-1.
- The U.S. government is caught in a terrible bind. On the one hand, if the government doesn't stand behind Fannie Mae and Freddie Mac, many overseas investors will see it as equivalent to the U.S. government defaulting on its debt. If the U.S. government walks away from Fannie and Freddie, these overseas investors will worry that the U.S. government will walk away from the other U.S. debt they own and from the dollar itself. There's already a suspicion among overseas investors that the U.S. government will try to solve its dual problems of a massive government debt and a massive trade deficit by letting the dollar tank. On the other hand, if the U.S. government does back Fannie Mae and Freddie Mac, it runs the danger that overseas investors will simply add Fannie and Freddie's $5 trillion in mortgages and guarantees to the $9.5 trillion the U.S. government already owes. By that calculation, a bailout would increase the debt level of the U.S. by 53% overnight.
Now, you may object that overseas investors are simply wrong in their beliefs. That Fannie and Freddie never had any government guarantee, explicit or implicit. That no bailout would turn that $5 trillion in owned or guaranteed mortgages at Fannie and Freddie into U.S. government debt.