Economic blackmail?

It's long been said that the U.S. relies on the kindness of foreigners to fund its ever-growing current account deficit. By the same token, our dependence on overseas investors and lenders also makes us vulnerable to external pressures that could be at odds with domestic needs and goals.

If you read between the lines of the following report by Bloomberg's Dawn Kopecki, "Fannie's Mudd Soothed Asian Investors as Bonds Rose," you get the distinct impression that the impetus behind the scramble to bail out the nation's largest mortgage lenders might have been a bit of economic blackmail by countries America is financially beholden to [italics mine].

Fannie Mae Chief Executive Officer Daniel Mudd was sitting down to a glass of wine with his wife at their Washington home around 10 p.m. on Saturday July 12 when Treasury Secretary Henry Paulson called.

Concerns about the financial health of the biggest U.S. mortgage finance company had driven Fannie Mae's borrowing costs to the highest since March the previous week and its shares had tumbled 45 percent on the New York Stock Exchange. Investors in Asia, the biggest foreign owners of Fannie Mae's $3 trillion of bonds, were asking the Treasury to bolster the government- sponsored company and its smaller competitor, Freddie Mac, said three people with knowledge of the talks.

Paulson told Mudd he had a plan to restore confidence in Fannie and Freddie, the core of the Bush administration's efforts to revive the U.S. housing market. "At that point, the proposal began to take form," Mudd, 49, said in an interview. "We're trying to solve a crisis of confidence. Would this do it?"

The next afternoon, before financial markets opened Monday in Asia, Paulson announced the rescue plan, saying he would seek authority to buy unlimited equity stakes in the companies and their bonds if needed, while the Federal Reserve would lend directly to Fannie and Freddie. Congress included the proposals in a broader housing bill that President George W. Bush signed into law last week.

Asian investors were among the most important groups to soothe because central banks, financial institutions and funds in the region own $800 billion of Fannie Mae and Freddie Mac's $5.2 trillion in debt, according to data compiled by the Treasury. U.S. officials were concerned that sales from the region would push lending rates higher, said the people, who declined to be named because the discussions were confidential.

Stocks Plunge

The extra yield investors demanded to own five-year notes of Washington-based Fannie rather than Treasuries rose to 101 basis points, or 1.01 percentage point, on July 9, from an average of 39 basis points over the previous five years.

Borrowing costs climbed and the companies' shares collapsed after analysts at New York-based Lehman Brothers Holdings Inc. said in a July 7 report that proposed accounting changes might force Fannie Mae and McLean, Virginia-based Freddie Mac to raise a combined $75 billion in capital.

Fannie tumbled 45 percent to $10.25 in New York Stock Exchange trading that week, while Freddie fell 47 percent to $7.75. A year ago both companies traded above $60.

At the height of the panic, Mudd dispatched two lieutenants to Asia to meet with debt investors. He declined to say which countries were visited, or the names of the officials.

`Extremely Worrisome'

Freddie and Fannie rely on foreign institutions. Investors and central banks outside the U.S. own about $1.3 trillion of Fannie and Freddie's corporate and mortgage bonds, according to the Treasury. Chinese institutions are the biggest holders in Asia. European investors own $300 billion of the securities.

"If they stop buying the agency debt, then yields would increase," Ajay Rajadhyaksha, the head of U.S. fixed-income strategy at Barclays Capital in New York, said in reference to Asia investors. "The costs would get passed to the consumers."

The average rate on a 30-year mortgage jumped to 6.59 percent on July 18 from 6.22 percent on July 11 as demand for the companies' debt waned, he said. If Asia started selling Fannie and Freddie holdings, "that would be extremely worrisome," Rajadhyaksha said.

Like when it announced the bailout of Bear Stearns Cos. by JPMorgan Chase & Co. on a Sunday in March, the Treasury rushed to pull together a statement on July 13 before markets opened in Tokyo.

Seen the Movie

Paulson, the 62-year-old former CEO of Goldman Sachs Group Inc., "knows the markets; he's seen parts of this movie before," Mudd said. The decision to allow Fannie and Freddie to borrow from the Fed's so-called discount window was meant to "send a message to the markets that it wasn't just a someday aspiration, but those confidence building measures are in place right now before Tokyo opens on Sunday night," he said.

Freddie CEO Richard Syron, 64, declined to comment.

Fannie was created as part of Franklin D. Roosevelt's New Deal in the 1930s, a time when the U.S. economy was struggling to emerge from the stock market crash, industrial production had tumbled 50 percent and the unemployment rate rose as high as 30 percent. Freddie started in 1970, when the economy was strained by the Vietnam War.

Both have the implicit guarantee of the U.S. government, so they can borrow at lower rates than banks and make money by purchasing higher-yielding mortgages from home lenders, providing new capital for loans. The companies own or guarantee almost half the $12 trillion of residential mortgages outstanding.

Primary Source

Congress and the Office of Federal Housing Enterprise Oversight, which regulates Fannie and Freddie, loosened restrictions on the companies this year, allowing them to buy more mortgages and temporarily purchase loans up to $729,500 in larger markets, compared with the previous limit of $417,000. The new legislation allows them to buy loans up to $625,000 in the 91 most-expensive markets.

The companies have become the primary source of cash for the housing market as banks and brokers, battered by $480 billion of losses and writedowns from subprime-contaminated securities, reduce lending. Fannie and Freddie were responsible for more than 80 percent of the mortgage bonds created in the first quarter, Ofheo said.

"The markets care as much about the government's comments about us, especially in this market," Fannie General Counsel Beth Wilkinson said in an interview. "If there's any kind of mixed message during a very volatile market it could be very detrimental to the GSEs and therefore the economy."

Marines in Lebanon

Mudd, the son of former CBS Evening News reporter Roger Mudd, has some experience with crisis management. While a first lieutenant in the Marines, he led the first platoon airlifted into Beirut on Oct. 24, 1983, one day after a truck bomb leveled a barracks that housed Marines dispatched as peacekeepers during Lebanon's civil war.

He ran General Electric Capital Corp.'s Asian businesses during the region's slump in 1998. In 2004, four years after joining Fannie as chief operating officer, he took over for CEO Franklin Raines as the company tried to recover from an $11 billion accounting restatement and securities fraud charges.

"You develop a pretty simple, straightforward set of priorities and marching orders," said Mudd, who'd canceled plans to spend summer weekends with his wife and four children at their rented vacation home in Nantucket. As the declines steepened, his wife flew home to support him, leaving the kids with her sister.

Yields Narrow

Yields on Fannie five-year debt narrowed to within 76 basis points of Treasuries. Fannie shares rose 1 cent today to $11.83 on the New York Stock Exchange, up from a 16-year low of $7.07 on July 15. Freddie declined 46 cents, or 5.8 percent, to $7.52, compared with its 16-year low of $5.26 the same day.

"Given the circumstances, he's done a pretty good job," David Dreman, chairman of Dreman Value Management LLC in Jersey City, New Jersey, said of Mudd. Dreman's firm held 10.4 million of Fannie shares at the end of March. He said he added to those holdings last quarter, though is "holding tight" now.

Fannie reports second-quarter results this month, and will likely announce a loss of 74 cents a share, or about $730 million, according to the average estimate of 11 analysts surveyed by Bloomberg. Freddie may report a loss of 60 cents, or about $388 million.

(Hat tip to The Market Ticker.)

Comments

[Deborah]

I am not sure I would call it economic blackmail. Would you expect a bank to continue lending to someone who didn't honor their debts? The bank would say you need to pay back what you owe or you can't borrow more.

I am not sure what foreigners would be doing except protecting their assets, which is somehow economic blackmail to the US?

Styron and Mudd say they are victims of circumstance, that nobody could have seen it coming. Mudd has stood in the headlights since 2004, had plenty of time to dodge the slow moving steamroller he gassed up. They are paid millions to not see it coming, now their biggest job is to salvage their reputations (Styron says). See the NYT article http://www.nytimes.com/2008/08/05/business/05freddie.html?pagewanted=1&_r=2. Poor little fellas, stay in the game! Failure of this magnitude gets rewarded. Nantucket's nice this time of year. Might run into somebody you don't want to see in DC or Northern VA. Cowards.

[Tim]

$11,648,409....Mudd's total fiscal year compensation working for a company that's bad debt has been nationalized. Good work if you can get it.

[BlackStarRanch]

...the calibre of my Marines must have decreased after '68-70. Lt. Mudd is a disgrace to the Corps. He should have told Paulson to take his solution and "pack it" where the sun don't shine. He's a disgrace for allowing it. Sometimes, you just have to say "Hell No", pack your sh** and leave. "Semper Fi"? - Not in Mudd's case!