A desperate but necessary bailout

The Treasury's intervention to shore up Fannie Mae and Freddie Mac allays the fears of foreign investors, but turning around the US economy will take something close to a miracle.
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Digg This By Jon Markman
The government's stunning takeover of troubled mortgage titans Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) on Sunday was sold to the public as a prudent, measured attempt to restore order to the U.S. housing market and keep people in their homes.
But look an inch beneath the public-relations job that most media outlets have accepted and you'll find the sad spectacle of a desperate borrower trying to stay one step ahead of its creditors.
The new plan put forward by Treasury Secretary Hank Paulson is a bailout all right. But not of Americans in Kansas and California who have lost their homes to foreclosure. Not by a long shot. Instead, it's an expensive ploy to keep the sovereign wealth funds and central banks of China, Kuwait and Singapore from foreclosing on their Fannie Mae and Freddie Mac debt and plunging the U.S. economy into chaos.
Announced on the first weekend of the new pro football season, the deal amounts to a frantic Hail Mary pass. It was a throw Paulson never wanted to make, as it exposes taxpayers to unlimited losses and violates every rule in the capitalist playbook, yet circumstances left him with few alternatives.
Twisting the Treasury's arm Major foreign investors, including more than 60 countries' central banks, hold more than $1.4 trillion in securities of U.S. agencies such as Fannie and Freddie, and they were getting extremely nervous as the two companies teetered on the edge of insolvency this summer. So were major U.S. financial institutions such as JPMorgan Chase (JPM, news, msgs) and Pimco, prompting the chief investment officer of the latter, Bill Gross, to pen a scathing article last week that warned of a financial "tsunami" if the U.S. Treasury failed to act quickly to guarantee their investments.
In late July, the Financial Times reported that the U.S. Embassy in Kuwait called that country's sovereign wealth fund managers to assure them of the soundness of U.S. agencies' bonds after the Kuwaitis announced they were not planning to buy the bonds in the future.
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Why Wall Street rescues are failingAround the same time, Yu Yongding, a Chinese economist and former adviser to China's central bank, warned that if the U.S. government allowed Fannie and Freddie to fail and international investors were not compensated adequately, the consequences would be “catastrophic."
He added: "If it's not the end of the world, it is the end of the current financial system."
Over the top? Not really, for U.S. mortgage loans had become the foundation of what Pimco co-CEO Mohammed El-Erian called the "global liquidity factory." If payments were scuttled, trillions of dollars that were borrowed against them in debt derivatives would become worthless, an event that had the potential to bring down countries, not just companies.
Video on MSN Money

Paulson on Fannie Mae and Freddie MacThe Treasury chief discusses the government's decision to seize the mortgage giants.Now that Paulson has made his play, Americans are exposed to incredible danger. If that sounds like hyperbole, do the math:
Of the $4.7 trillion in U.S. debt already in private hands through last week, $2.4 trillion, more than half, was held by foreign investors. The Paulson plan to take over Fannie and Freddie adds an additional $5.4 trillion to U.S. debt, of which $1.4 trillion is owned by foreigners. Thus Paulson has committed to doubling U.S. debt and increased foreign exposure by around 50%.
This is plainly a troublesome matter on its face and may affect the country's overall sovereign credit rating. Now add to this exposure the likelihood of a sharp rise in demand for funds from the Federal Deposit Insurance Corp. and increased demands from the Federal Home Loan Bank system -- and consider that the U.S. faces slowing tax revenues from falling incomes amid swelling joblessness and recession -- and you begin to understand the size of the risk Paulson is taking in our behalf.
A bad choice -- and the only one Satyajit Das, a credit derivatives expert based in Australia who first helped us understand this mess a year ago (see "Are we headed for an epic bear market?"), concludes that it may mean the end of the U.S. dollar as the world reserve currency, which creates a different set of problems.
Yet Das has looked at the problem inside out and concluded that the Treasury secretary had little alternative. "What Paulson is doing is trading today for tomorrow -- struggling to survive to be able to come back and fight another day," Das concludes.
So will the plan work?