On September 8, 2008, the United States government took control of two of the
largest financial enterprises in the world, Fannie Mae and Freddie Mac, an
event that carries a great deal of meaning for the People's Republic of China
(PBoC), China's central bank.
This article will explain the origin, mechanics, and consequences of the
nationalization of Fannie Mae and Freddie Mac, and consider all of these
elements in light of the Sino-American relationship.
Fannie Mae was founded in 1938 as part of Franklin Roosevelt's New Deal. The
purpose of Fannie Mae was to enable and encourage Americans to purchase private
homes. When an
individual needs a mortgage to buy a home, a community bank lends money to the
individual.
Once the money is lent out, the bank can no longer use that money to make other
loans. Fannie Mae was founded as a government entity to swoop in and buy up
mortgages from community banks, thereby replenishing their coiffeurs and
allowing them to make more loans.
Fannie Mae, in turn, takes all of these old mortgages and repackages them as
special bonds, known as mortgage backed securities (MBS), which are sold to
investors around the world. Fannie charges a fee for this service, which is the
basis of its profitability. This is what is known as the secondary mortgage
market.
In 1968, Fannie Mae was transformed into a private corporation with private
management and stockholders. In 1970, the US Congress created Freddie Mac,
another private corporation, to compete with Fannie Mae. Although Fannie and
Freddie were both were fully private - meaning that stockholders owned the
firm, controlled the firm, and reaped its profits - both enterprises retained a
special relationship with the United States government, and as a result,
enjoyed special privileges.
Fannie and Freddie are known as Government Sponsored Enterprises, or GSEs.
There has long been a popular perception that the GSEs are government owned or
receive government subsidies, neither of which is not the case. Although the
GSEs are neither government owned nor do they receive any concrete subsidies
from the government, they nonetheless enjoy special treatment from the
government.
According to a 1996 assessment by the Congressional Budget Office, "[GSEs] are
costly to the government and taxpayers ... the benefit is currently worth
US$6.5 billion annually." [1] This unearned benefit, on the order of several
billions of dollars per year, is what enabled the GSEs to totally dominate the
secondary mortgage market and annihilate any competition arising from private
sector firms that did not enjoy this benefit.
Because the GSEs were created by the congress for policy purposes, and because
of the GSEs' unique lobbying clout in Washington, and because the GSEs were
absolutely vital to the functioning of the American economy, it was widely
believed that the United States government would never allow the GSEs to fail
commercially.
On this basis, large institutional investors viewed the bonds issued by the
GSEs as being equally secure as the bonds issued by the United States Treasury
Department, which are by definition the safest investment instruments in the
world. Trillions of dollars of GSE bonds were purchased by mutual funds,
insurance companies, sovereign wealth funds, and central banks around the
world, all on the premise that these bonds could never be repudiated.
Community banks, thinking that they were immune to the risks from unqualified
borrowers because they could immediately unload bad mortgages on the GSEs, made
increasingly more dangerous loans. The GSEs, in turn, thought that their
exposure to risk was low because they could immediately repackage the loans as
bonds and unload the risk on investors. In this process, both the community
banks and the GSEs would profit without having to shoulder any real risk.
This encouraged them to go mortgage crazy, often lending and spending money
that they didn't really have. Critics warned that the recklessness of the GSEs
called for greater government regulation. In response, the GSEs spent a fortune
to lobby the government to avoid increased regulation. Over the last decade,
Fannie Mae spent $79.5 million on lobbyist fees and Freddie Mac spent more than
$94.8 million. [2] As a result, the regulation never materialized.
Over the last few years the primary mortgage market in the United States
started to go bad. As homeowners stopped being able to pay their mortgages, the
bonds which the GSEs had sold to investors began to look menacing. They
obligated the GSEs to repay the investors the principal amount which they had
invested plus interest, but the GSEs were receiving neither principal nor
interest payments from mortgage holders. Thus, the bonds began to earn negative
profits for the GSEs. As their resources and assets disappeared over the last
year, the stock prices of the GSEs plummeted.
In October 2007, Fannie and Freddie's stock prices were about $67 per share and
$63 respectively. When the stock market closed for the weekend on Friday,
September 5, 2008, the stock prices had fallen to about $7 and $5 respectively.
The United States government watched nervously as this precipitous decline took
place. Then, finally, on Sunday, September 7, the government exercised a plan
to take control of the GSEs in order to rehabilitate them. The government
immediately dismissed the CEOs of both GSEs.
The plan required the GSEs to issue a round of stock to the Treasury
Department, which would dilute the value of the existing shares and leave the
Treasury Department as the controlling shareholder with an 80% ownership stake.
The plan also required the Treasury Department to open a line of low interest
credit to the GSEs, and to buy $5 billion worth of GSE-issued bonds. These
latter measures were intended to immediately shore up the capital base of the
GSEs.
It is expected that the government will have to spend a lot more money in the
long term in order to rehabilitate the GSEs. The plan calls for the government
to spend as much as $100 billion per enterprise, if needed.
When the markets opened up on the morning of Monday, September 8, many
institutional investors were relieved by the takeover because it meant that the
United States government was now fully guaranteeing the bonds which had been
issued by the GSEs. Other investors, however, were not so happy. The price of
Fannie and Freddie opened at $1.91 and $2.50 respectively, and closed around
$0.72 and $0.88 respectively. Anyone with a large ownership interest in the
GSEs was ruined.
The outgoing CEOs of Fannie and Freddie have been in control of these
enterprises since 2004 and 2003, respectively, and it seems as though they did
not take nearly enough precaution to prevent this disaster from occurring. On
the contrary, they presided over a period of increased lobbying efforts to
avoid government regulation, which may have otherwise averted this disaster.
Thus, their responsibility for the downfall of these enterprises is somewhere
between passive negligence and outright guilt.
Nonetheless, the CEOs of Fannie and Freddie are leaving office with severance
packages of $9.3 million and $14.1 million respectively. It seems downright
unjust to reward these two men so handsomely for inflicting so much disaster
and worry on so many people.
It is interesting to note the connection between the GSEs and the PBoC. A sum
equivalent to almost 10% of the gross domestic product of China was invested in
the GSEs in the form of bonds. According to an estimate by Standard &
Poor's, the PBoC owned roughly $340 billion of GSE bonds. One of the greatest
worries for Chinese policy makers over the last few weeks has been the anxiety
of the uncertain prospects that the GSEs would honor their debts. If the GSEs
had repudiated their debt, the losses to the Chinese people would have been
devastating. Today, China rests easy upon the knowledge that those debts will
be honored. But policy makers, both Chinese and American, must draw some
important lessons from this experience.
American spokespersons very frequently criticize China because the Chinese
government is so deeply involved in the Chinese economy. China's state-owned
enterprises (SOEs) often dominate the most profitable and most strategic
sectors, such as infrastructure and telecommunications. American spokespersons
say that this is unfair and unsafe, and certainly not befitting of a
free-market country in the 21st century.
However, upon reflection, the secondary mortgage market is an incredibly
profitable, incredibly strategic sector. The GSEs dominated this sector using
their special relationships with and unearned privileges from the United States
government. When things started to go bad, the American government, led by the
most overzealous free-market administration in modern history, fully
nationalized these enterprises.
The point is that America's devotion to free-market concepts is hardly
sacrosanct, and it appears quite hypocritical to criticize others for behaving
in a similar fashion. So the next time American spokespersons intend to offer
criticism of China's SOEs, they would do well to stop and remember America’s
GSEs
And the next time Chinese spokespersons intend to reject American criticism of
Chinese SOEs, they would do well to remember why America's GSEs failed.
The GSEs' special relationships with the American government and the unearned
privileges that resulted from these relationships insulated them from the
realities of the market and thereby induced them to behave irresponsibly. Both
sides could benefit greatly from this experience by developing a better
understanding of why the perceptions of the other side form the way that they
do.
Notes: 1. Congressional Budget Office, Assessing the Public Costs and
Benefits of Fannie Mae and Freddie Mac, May 1996
2. Eric Dash, "Few Stand to Gain on this Bailout, and Many to Lose." The New
York Times. September 8, 2008.
Richard Komaiko researches Sino-American relations, economic policy,
terrorism and national security. He holds a degree in economics from the
University of Illinois and has studied Chinese language and culture at the
University of Illinois, University of Chicago and the Beijing Institute of
Education.
(Copyright 2008 Asia Times Online (Holdings) Ltd. All rights reserved. Please
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And yes again that Komiako may have overstated a little bit to make his point.
But his point is still valid. Despite China has privatized many businesses, it
is still a fact that the Chinese government still keep its hand in SOEs,
particularly those in the so-called strategic industries. PetroChina, Sinoec,
CNOOC are all listeed at home and overseas, but Beijing still impose price
control on oil products and give them subsidies. But yes, China is moving
toward the direction of reducing government intervention in SOEs. So your pont
that China is moving away from SOEs, the US is moving towards them is
excellent.
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