Fannie and Freddie Bailout: Politics and Financial Implications

Here we are on the cusp of a government led financial bailout for Fannie Mae and Freddie Mac. If credit markets reached a pinnacle of potential massive structural change, now is that peak. Freddie and Fannie are the current mortgage market. With the collapse of the "shadow banking system" Government Sponsored Enterprises are the only firms lending. Where does all of this money come from? Overwhelmingly, the Chinese. The Chinese are the largest buyers of Agency bonds. Agency bonds provide a better rate than T-Bills and they are "Government Sponsored", but not Government backed, I should add. The Chinese investment in US Agency Bonds fueled the housing boom. But now, the boom has gone bust along with the equity of the GSEs. The bonds have severely deteriorated in value, thereby eroding the lender's asset valuations. So how much is needed to bail out these enormous financial institutions? Paulson has proposed a $300 Billion bail out plan. Let me say that again...$300 Billion. Paulson will extend both a line of credit and allow the Treasury to purchase equity in Freddie and Fannie may. Clearly, Paulson's plan created new demand for GSE stock in the midst of a total collapse. A plan, not necessarily a congressional approval is shoring in its own right. I think the US Government lacks the resources for a bail-out of this size. It can lend to the GSEs and continue to pay the Chinese interest on non-performing mortgage backed bonds. I suspect the demand for such bonds will fall sharply considering the public knowledge agency debt is only backed by the Government and not performing assets. As bonds are dumped on the market interest rates will rise as they react inversely to the value of the paper. I see a flight of capital from the US, a continued fall in the dollar, the eventual de-pegging of the Chinese and Middle East Currencies (including the Yuan and Riyal), and higher interest rates as bidding for loans gets more competitive. The question is, where will all of the "conservative" quality capital go?