Chinese Warns Paulson On GSEs

A high-ranking Chinese economist has told the US in no uncertain terms to fix Freddie and Fannie or else. "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, .. If it is not the end of the world, it is the end of the current international financial system."

Yu Yongding is possibly the most highly accredited economist in China.

Men like Yu Yongding don't just get up one morning and say this sort of thing. US Treasury Secretary Paulson was put on notice.

Max Fraad Wolff, an editor of the website GlobalMacroScope explains: "Fannie Mae's June 2008 statement declares a gross mortgage portfolio of $US750 billion and guarantees of mortgage backed securities and loans of $US2.6 trillion. Freddie Mac's June statement details a retained portfolio balance of $US792 billion and a total mortgage portfolio balance of $US2.2 trillion. These two giants have retained interest in over $US1.5 trillion and guaranteed over $US4.5 trillion in mortgages, mortgage backed securities and loans. There are $US11 trillion in outstanding mortgage liabilities in the US."

"The extent of the firms' guarantee commitments is global in scope. Sixty-six global central banks buy loans bundled and or backed with Freddie Mac and Fannie Mae involvement. As of June 30, 2007, foreign entities and individuals held over $US1.4 trillion in securities of US agencies such as Freddie and Fannie … They have been caught with weak financials, swollen balance sheets and escalating default, just like the homeowners they assist. The size of their retained mortgage portfolios is truly gigantic."

The Chinese have basically said "we have spent 10 years of savings on your junk and it is getting close to high noon" - and the US has come quickly to attention. For the Chinese have not declared war, but issued a statement of intent. It might have been ignored by much of the planet, but the US Fed, to whom the statement was directed, took note.

The Chinese are not entirely happy with the fact they have been faithfully buying Freddie and Fannie and Ginnie and all the Macs and Maes, that is coming to haunt them in a big way. Their fear is that the US might be speaking with a forked tongue. They are starting to remember the history of Western behaviour and it has come upon them that they might be played for suckers, big time.

The temporary surge in US dollar bough Paulson some time, but it now looked pretty fake. The Chinese realise Paulson will soon be gone. He refers now to the next administration.That does not go down well with the Chinese. Suddenly it seems to have occurred to China that US administrations change and so do priorities and promises. Solemn treaties forged over years on matters as grave as strategic arms limitation and Geneva Accords, two rather important ones that spring to mind, can be dropped.

Freddie and Fannie shares had recovered a tad since they touched 20-year lows on last Monday on speculation that a government bailout will leave the stocks worthless. Help from other central banks has poured in. The new-found strength of "Mac and Mae" had observers reflecting they might not need the US government bailout with some going so far as to suggest that the two might return to health. But the hole "Mac and Mae" have dug is almost unfathomable.

Meanwhile a host of reports show that individual foreign investors are dumping US securities. Paulson is hoping that a quiet bailout of Fannoe & Freddie will be in the offing. Does not look likely at all.

The biggest factor the Fed and the Treasury will be considering when thinking whether to raise rates is the amount of recapitalisation, the amount of mortgage resetting, and the various restructuring that is ongoing to help the smaller and regional banks to survive. Any rate hike would affect the above issues negatively. The Fed and Treasury cannot allow that to happen.

Hence, to me the fed funds rate has almost minimal chance of being hiked for the rest of the year. I see a 60% for it to stay at 2% for the year, and a 40% that it may go lower to 1.75% before the year is over. That being the case, there is very little chance for USD to maintain its rally.

The US Treasury Department already unveiled a plan that would increase the government's US$2.25 billion credit lines to Fannie and Freddie and allow the government to buy an equity stake in either company.

To give an example of how much GSEs are out there - last year China bought US66bn in GSEs debt and only US12bn in US Treasuries. Russia bought US34bn of GSEs debt and SOLD US22bn of US Treasuries. So, the Treasury and Fed have to quickly rescue Fannie & Freddie with absolutely no hiccups in congress.

Anything less than that will see bond prices of GSEs debt falling like a rock and USD being pummeled by at least 10%-20%. While that is the "potential bad news", we should remember that Paulson and Bernanke also know that - hence its a postulation at best now, let no one go and do something silly like NOT fully rescuing Fannie & Freddie.You hear it here first, Fannie & Fredddie will be nationalised.

p/s photos: Son Dam Bi