More on the bailout

Most of the analysis of the Treasury's takeover of Fannie and Freddie focuses on the need to cope with the housing crisis. But the most important motivation to do this now was to prevent a financial crisis. It is important to note that a large portion of the debt of the two corporations was held by foreigners.

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."

This capital inflow is a response to large US current account deficits. The debt of the GSE's, while not explicitly guaranteed, clearly bore an implicit Federal guarantee (as is now totally evident). Foreign investors who purchased GSE debt were naturally worried. If the GSE's went bankrupt they would perhaps gain cents on the dollar. The bailout announced by the Treasury will hurt shareholders, but will probably keep bondholders whole. Hence, the bailout reassures foreign investors at a time when we need them.

Of course what remains to be seen is whether the current bailout plan will suffice. As many have noted (for example, Paul Krugman here, or Mohamed El-Erian here), we are now in a process of de-leveraging. This is the reverse of the process in the boom when leverage is used to maximize returns. Now the race to safety means a rush to sell assets to bolster balance sheets. But what is good for the individual may not work for the economy as a whole. The rush to sell drives down prices which further worsens balance sheets and leads to more selling. Liquidity dries up. This is Irving Fisher's debt deflation. Japan went through this in the 1990's. Can we escape it?