Fannie Mae, Freddie Mac Bailout: We Are Now at the Mercy of the Chinese

If you watch the news at all these days (and a case could definitely be made for avoiding this habit), then you already know that the United States imports way more cheap stuff from China than it sends over there for sale to the Chinese people. That big difference between the huge amount we import and the tiny amount we export is called the trade deficit, and you’ve almost certainly been hearing for eight years now about how it keeps going up and how that isn’t such a great thing.

What you may not realize, however, is that the recent federal bailout of the mortgage giants Fannie Mae and Freddie Mac stems in part from the strange and delicate trade relationship the U.S. has forged with China; a relationship that consists of lots of imported Chinese goods that Americans buy up with money that is essentially loaned to the U.S. by, you guessed it, the Chinese.

The Chinese do not issue loans directly to the U.S. the way that a bank would issue a loan to an individual. What the Chinese government does instead is buy up U.S. debt, mostly in the form of mortgage-backed securities. The recent tax rebate stimulus package designed to get shoppers out and spending money again to shore up the flagging U.S. economy came largely from this kind of investment by the Chinese in the debt held by American financial institutions.

While it may seem circular and confusing to think of the Chinese actually loaning the U.S. the money to buy Chinese products, the fact is that right now the U.S. government is heavily dependent on this kind of Chinese investment just for the continuation of its day-to-day business. In other words, without Chinese money being poured into the U.S. in the form of securities purchases, our government would experience such a budgetary shortfall, it would have to shut down.

The linchpin in this arrangement, obviously, is U.S. housing values. If the value of the properties backing the mortgage debt purchased by the Chinese remains stable or increases steadily, everything continues to hum along normally (or at least normally on the surface of it). The Chinese have an asset they see as increasing in value (that is, American mortgage-backed debt securities), and the U.S. government has the money it needs for its day-to-day operations. The Chinese make money off of their exports to the U.S. and off of their investments in U.S. housing-backed debt, and U.S. citizens continue to consume the cheap Chinese goods we have grown accustomed to buying.

That’s the U.S. consumer economy in a nutshell, and if it sounds a bit Orwellian, bizarre, and unbalanced, that’s because it is. Nevertheless, that’s how we roll these days, or did, until the housing bubble burst and the values of the properties actually backing all this mortgage debt began to drop precipitously. At first it was only subprime debt that went bad, but that spread to what is known in the mortgage industry as Alt-A debt (which is a notch above subprime and once considered quite a safe risk).

Now even homeowners who are in no danger of defaulting on their mortgages are seeing dramatic drops in their property values due to a badly inflated housing market and the subsequent bursting of that bubble. And as if that isn’t all bad enough, the problem is rapidly spreading to other kinds of U.S. debt: credit cards, car loans, home equity lines, and small business lines of credit.

To put it in just a few words: the actual assets backing U.S. debt are now depreciating instead of appreciating in value, leaving the Chinese holding substantial investments in the U.S. that are looking less and less profitable. The Chinese have been friendly to the U.S. because they are making lots of money from the relationship. With the bursting of the housing bubble, not so much. They have been growing more and more nervous about this fact.

What does that have to do with Fannie and Freddie?

Fannie Mae and Freddie Mac back most of the mortgage debt in the United States, but because they have always had a quasi-governmental status, they have not kept the kind of prudent reserves on hand that a private financial institution would be required to keep to mitigate such losses. As it became more and more clear over the course of the past year or so that Fannie and Freddie didn’t have adequate financial reserves to back the debt they held, the Federal Reserve and the Treasury Department began to talk about a bailout.

It’s a bad thing that housing values are plummeting in the U.S., but it has to happen because they were so wildly inflated during the boom years. That hard correction would be painful for the U.S. no matter what, and we are certainly feeling the pain already in the form of a major economic turndown that looks like it will last at least through the better part of 2009. But what would be even more catastrophic than the pain we are already feeling in our collective national pocketbook would be a decision by the Chinese to pull back on their investment in us. Such a move would literally throw us into a financial meltdown that would make the Depression era look pretty cheerful by comparison.

So, while it may or may not be true that Fannie and Freddie “are too big to be allowed to fail,” what is unquestionably true is that the U.S. government is too big to be allowed to fail, and fail it would without a steady influx of Chinese money.

All of this is more food for thought that I can possibly digest in a single sitting. If you pay close attention to the expressions on the faces of Bernanke and Paulson, you may well detect a hint of dyspepsia there, too.

The day is saved. Again. For now.

And yet once again, in the smoking (and indigestible) aftermath, a familiar and phrase rears its ugly head:

“What next?”

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