Fed Bailout of Freddie and Fannie For Foreign Investors or American Citizens?

The Financial Times has a great article this morning on why the Feds took over Freddie Mac and Fannie Mae. The primary discussion in the real estate blogosphere is the impact on lending and consumers. But the second and long term reason is that confidence by foreign investors has been severely tested.

The soaring debt being created by the United States combined with a rapid deflation of housing and banking assets has spooked investor from overseas. If the flight of capital that has started turns into a rout there could be severe complications for the long term fiscal health of the United States.

The Freddie Mac and Fannie Mae situation was a bellwether moment. With Secretary Paulson’s actions he is signaling that the country will stand behind our financial institutions.

The intervention has a second purpose too: to shore up confidence among foreign investors. Throughout the credit crisis, policymakers have worried about the risk of a flight from US assets that would greatly aggravate the credit crunch, forcing a brutal adjustment in US savings and investment.

Since mid-July foreign central banks reduced their holdings of Fannie and Freddie debt by $18bn (£10.2bn) in a clear sign of a loss of confidence.

As Treasury secretary of a debtor nation, Mr Paulson was determined to keep faith with the world’s investors - honouring the assumptions on which they invested.

However, the ability of the US government to drive down mortgage rates and to reassure foreign investors is constrained by the need not to push up its own borrowing rates by taking on too much debt and mortgage risk. US public finances are already strained.

Of course the financial bailout is also for the US consumers and homebuyers. The Financial Times explains why this also benefits all Americans, both in and out of the housing market.

Assuming the US can drive down mortgage rates, the question is how much of an impact this will have on housing, financial markets and the economy.

Mortgage rates are not the main reason why house prices are falling. Stocks of unsold homes are high, prices are still elevated on some measures, the risk of local foreclosure spirals remains high, and unemployment is rising.

So while lower mortgage rates should improve the base case outlook for housing, they may not radically alter it. Still, the takeover significantly reduces the risk of a total collapse in house prices. This in itself increases the value of housing-related assets and bank stocks, which rallied yesterday.

Mortgage rate cuts could trigger a refinancing boom, putting cash in the hands of consumers and supercharging the effect of past Fed rate cuts.

Moreover, if banks are less afraid of further losses on mortgage-related securities, they should be more willing to extend loans, moderating the credit squeeze. via FT.com