Will Asian investors rescue the U.S. mortgage giants?

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ImageThe short answer appears to be no, but let’s start at the beginning…as anyone who has been following the financial markets now knows, the mortgage market in the U.S. is in serious disarray and the prospects for recovery are not positive.  Some observers are calling it the worst housing crisis since the Great Depression of the 1930s.  Housing prices have been in a freefall over the past year, set off by the losses in the sub-prime mortgage market.  House prices have dropped by over 14% on average and substantially more in many major metropolitan areas, and delinquency rates are on the rise across the board – all of the key indicators (pdf) are flashing red. 

The two largest backers of the mortgage market in the U.S. are “Government Sponsored Enterprises” (or GSEs), which guarantee about $5.2 trillion of mortgage debt, or close to 50% of the total mortgages outstanding.  These GSEs – Fannie Mae and Freddie Mac – were designed to stimulate housing ownership by guaranteeing mortgage loans and issuing mortgage backed securities.  Although the GSEs are privately held without an explicit Government guarantee of their debt, now that they have posted major losses due to the housing market downturn and may be undercapitalized (both companies shares have fallen by about 90% since onset of the crisis one year ago), they are now under an explicit U.S. Treasury plan to provide liquidity and purchase equity in the GSEs if necessary.    

So, what does this have to do with Asia?  Well, investors outside of the U.S. own $1.3 trillion in bonds issued by Fannie Mae and Freddie Mac, and of these investors, Asian investors are the largest.  In fact, China is the largest single foreign holder of GSE bonds at $376 billion and estimates indicate that the current holdings may be much higher, and the primary investor is likely the central bank.  However, just this week, evidence has emerged that Asian investors are losing their appetite for Fannie and Freddie’s bonds and do not have confidence in the financial health of the GSEs or in the U.S. Treasury plan to back the mortgage giants.   The news this week was that Freddie sold $3 billion of five year bonds this week and Asian investors bought 30 percent, but this is way down from the 41 percent purchased of the last five year bond issuance done only in May.  Thus, it appears that Asian investors will not be riding to the rescue of the two mortgage giants anytime soon. 

What difference does it make in Asia if they buy less GSE bonds?  If the Asian investors stop buying the debt of these two GSEs, it could help to push up the cost of issuing their bonds (or the yield) will go up.  This in turn would get passed on to home buyers, further exacerbating the problems in the U.S. housing market.  In fact, this has already happened as the lack of investor confidence in the GSEs and their bonds is now translating into much higher yields on GSEs bonds – Freddie’s bond issuance this week had a record high spread over U.S. Treasuries (60% higher than the spread in May).  In addition, as the yield goes up, the GSEs ability to continue to guarantee mortgages at lower rates will be reduced. 

Thus, these two factors are beginning to be passed through to the mortgage market and interest rates on most forms of residential housing loans have risen steadily.  Given that this cycle will exacerbate the current U.S. housing crisis, it will flow through to the real economy.  The economic downturn in the U.S. is now being felt across Asia in many areas and if the GSEs are not fixed soon, there is strong potential for the economic slowdown to be more severe and prolonged.  Again, this will be even worse for the economies and financial markets in Asia.  These concerns were revealed in dramatic form this week.  The news that the U.S. Treasury would likely need to bailout the GSEs very soon prompted the share price of Fannie and Freddie to drop by 22% and 25% on August 18, which then (in part) caused Asian equity markets to immediately fall to some of their lowest levels in two years

Despite the potential dangers the GSEs pose to Asia, at least indirectly, it seems that Asian investors will not be coming to the rescue of the U.S. mortgage giants.  Obviously, risk-return dynamics will primarily drive their decisions.  However, maybe there is an underlying strategy to this approach – the less Asian central banks and financial institutions buy of GSE bonds, the more likely it makes the prospects of a direct U.S. Treasury bailout of the GSEs.  If this is the approach, it looks like it might be working as the Treasury seems to now be shifting its position on the GSEs. 


James Seward

Senior Financial Officer

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