How do we all pay for the bailout of Fannie Mae and Freddie Mac?

July 14th, 2008

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Last week, the US Federal Deposit Insurance Corporation (FDIC) took over IndyMac, an insolvent US$32 billion Californian mortgage bank. As if this is not bad enough, two of the America’s largest government-insured mortgage lender, Freddie Mac and Fannie Mae, were losing the market’s confidence in their solvency status. The level of confidence was so low that both the Treasury and Federal Reserve had to step in over the weekend to announce their plan to prop them up. This look to be reminiscent echo of the Bear Stearns bailout in March this year (see New tricks required to bail out financial system).

For those who do not yet already know, Freddie Mac and Fannie Mae are US government-sponsored enterprises (GSE) in which their bonds are insured by the US government. That is, if the US home-owners default on their mortgage debt, the US government will ‘insure’ the shortfall between what they are obliged to pay to their investors and lenders and what they collect from the impaired mortgage debt payments. Now, they can be regarded as insolvent. As we explained before in Banking for dummies,

… the banking business is a balancing act of managing a portfolio of assets and liabilities.

This means that Freddie Mac and Fannie Mae, thanks to the rising debt default of American mortgages, is failing to do a proper job in the balancing act. As we explained with an example in De-leveraging in the real economy- mortgages, with falling house prices and rising debt defaults,

… if house price goes down by more than 10%, then the home ?owners? will not only lose their savings for the 10% deposit, they will still owe the bank money after the house is foreclosed. In the US, house prices have fallen by 13% in one year. So, you can imagine that there will be a lot of misery going on.

Make no mistake about it: this development is highly serious. To give you a sense a scale of the problem, consider this (as reported in this news article- Federal Reserve to rescue US mortgage giants):

  1. Both of them owns around US$5 trillion worth of mortgage bonds, which is almost half of all mortgages in the US.
  2. US$ 5 trillion is the GDP of Japan, the world’s second largest economy.
  3. As at June 2007, foreigners hold US$1.3 trillion long term debts issued by all GSE (which includes Freddie Mac and Fannie Mae). This was 21.4 percent of the total debt. China and Japan holds US$376 billion and US$229 billion of these debts respectively.
  4. The rest of them are held by mum and dads, state and local governments, banks, insurance companies, pension funds, retirement funds, money markets, managed funds and so on.

As you can see, if Freddie Mac and Fannie Mae fail, it will not not just affect the US. Financial assets all over the world will be affected. It could be your superannuation and pension funds holding the bag of worms!

We believe the de-leveraging process still has to continue (see Is the credit crisis the end of the beginning?), it will only be a matter of time before Freddie Mac and Fannie Mae will really become insolvent. If a US government-insured bond becomes defaults on its debt, it will be as good as a default by the US government on its debt. If that ever happens, you can be sure this will descend into an extremely ugly global US dollar crisis. Therefore, both of them are too big to fail.

The only way out of this is, as we explained before in Recipe for hyperinflation,

… once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.

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