China Proactively Dumping Fannie/Freddie Debt In Favor Of Treasuries

FT.com has reported that the Bank of China has sharply reduced its Fannie/Freddie securities holdings but sharply increased its holdings of US Treasuries. Is this a sign of things to come?  Do they know something we don’t?

This is exactly the reason the Treasury should not give an open-ended, retroactive and explicit guaranty of the trillions in mortgage guarantees made on some of the worst loans to ever come out of the USA.  While retroactively protecting a group by backing the debt, you throw those who own US Treasuries under the bus. That would be a real blow to investors and a much broader base of investors at that. I talked in detail about this earlier this week in my piece here.

Remember, Fannie and Freddie have near $700 billion in subprime and Alt-A combined.  Much of their Prime paper is many grades lower than originally rated due to their faulty automated underwriting systems, DU and LP, during the bubble years.  Much of the mortgage backed debt is owned by foreign Government’s, banks, mutual funds, pension funds and rich investors such as Bill Gross and his customers.

If a retroactive, explicit and open-ended guaranty is given on debt that has never been guaranteed in the past, just as defaults and foreclosures are surging among all paper grades and with house prices continuing to crash, it could be disastrous for US Treasuries.  We have no idea about the default rate on loans the GSE’s made, but rest assured it will be much higher than everyone thinks. Without the guaranty, the trillions in mortgage backed debt may lose some value but the implications are not as great as with Treasuries.  The loss is manageable.

Bill Ackman actually spoke about a great plan to solve this problem and adequately back investor, which is important and needless to say most important to the investors. You can read about it here and here.

Threats are flying already. But what does “compensated adequately” mean? Perhaps ownership in the new Fannie/Freddie if indeed their GSE holdings lose value. This would pay big over the next 10-20 years but likely would involve a loss in value immediately.  And, they are not considering what would happen to US Treasury values if Fannie/Freddie debt is and open-ended, retroactive and explicit guaranty.

“A failure of US mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system”, Yu Yongding, a former adviser to China’s central bank, says.

“If the US government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,” Yu said in e-mailed answers to Bloomberg. “If it is not the end of the world, it is the end of the current international financial system.”

There should no problem with explicitly guaranteeing loans going forward after the firms are nationalized. As a matter of fact, the GSE’s are making some of the best loans ever. With an explicit guaranty going forward, tighter lending guidelines and higher mortgage rates and spreads over Treasuries, investors should have no problem buying up the issues.  They would be in such hot demand that it could conceivably make actual mortgage rates cheaper on the front end than they are today.

Without an explicit, retroactive and open-ended bailout that saddles the US tax payer with TRILLIONS in liability, people are worried that these players, especially foreigners, will quit buying US Treasuries. Well, that’s the risk you take.  But at this point in time that is just speculation.

As clearly reported in FT.com, many of these investors have already significantly lightened their US Treasury exposure.  Strangely enough, even more so around the time the news began to broke that the Government was considering retroactively backing $5.2 Trillion in Agency debt and RMBS’s.

The FT article can be found here.

Subscribe by RSS Subscribe by Email