Overseas investors take hard look at U.S. mortgage giants

By Heather Timmons and Julia Werdigier

Published: July 21, 2008

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NEW DELHI: For more than a decade, Fannie Mae and Freddie Mac, the housing giants that make the American mortgage market run, have attracted overseas investors with a simple pitch: The securities they issue are just as good as the U.S. government's - and they usually pay better.

The marketing plan worked: About one-fifth of securities issued by Fannie, Freddie and a handful of much smaller quasi-government agencies, some $1.5 trillion worth, were held by foreign investors at the end of March. One-tenth of all American mortgages are, in effect, in the hands of institutions and governments outside the United States.

Now that the two companies are at risk, these foreign holders are watching closely to determine the future of hundreds of billions of dollars of investments. How Fannie and Freddie's rescue is handled will ultimately test the world's faith in U.S. markets and could influence the level of interest rates and weigh on the strength of the dollar for years to come, analysts say.

"No less than the international perception of the credit quality of the U.S. government is at stake," said Richard Hofmann, an analyst with Credit Sights, an independent research house with offices in London and New York.

Also at stake is the ability of Americans to access credit in the future. If foreign companies and governments abandon these investments, home, auto and credit card loans will be much more difficult to come by.

That helps explain why Treasury Secretary Henry Paulson Jr., who is responsible for preserving the full faith and credit of the U.S. government, is pressing American lawmakers so hard to provide him with the authority to inject unspecified billions in cash into either company.

The "blank check" nature of his request raises hackles among some in Congress, but Paulson is counting on the fear of much worse to come if nothing is done to rescue Fannie and Freddie to win the battle on Capitol Hill.

The total exposure of foreign creditors to Fannie- and Freddie-issued bonds makes the scope and depth of the subprime mortgage crisis look like child's play.

Asian institutions and investors hold some $800 billion in securities issued by Fannie and Freddie. The bulk of this is held in China and Japan, with $376 billion and $228 billion, respectively, according to the most recent country-specific Treasury figures, which date to June 2007. Bank of China, a major state-controlled Chinese bank, has $20 billion in exposure, estimates CLSA Group, or about 2.6 percent of its total assets.

In Europe, roughly $39 billion in Fannie and Freddie debt is held in Luxembourg and $33 billion in Belgium, which are both home to large investment management firms. Investors in Britain hold $28 billion and Russian buyers took $75 billion. Sovereign wealth funds in the Middle East are also believed to be big investors in Fannie and Freddie debt.

The trillions in securities issued by Fannie and Freddie and backed by U.S. mortgages were never explicitly guaranteed by Washington. But the integral role they play in the housing market and their own marketing pitch has always meant, to foreign and domestic investors alike, that the guarantee would be backed up if it were tested.

Asian banks and insurers bought this paper in large numbers because it was something that would give "a little more yield than you might on a straight Treasury - the same risk at a better price," said Deborah Schuler, an analyst with Moody's Investors Service in Singapore.

As the U.S. government debt, and the corresponding amount of Treasury securities, shrank in the late 1990s, foreign investors with currency reserves needed a safe alternate place to park their cash. Fannie and Freddie stepped up their overseas marketing efforts at the same time, and with the help of a wide array of Wall Street banks, sold off billions of dollars in securities overseas.

Investment managers at Asian banks and central governments are "very comfortable with the idea of implied government support" because it is so prevalent in Asia, Schuler said. Still, debate in Congress on the issue "is going to worry people."

The worst-case scenario is that "we're all wrong and the government turns its back" on Fannie and Freddie, she said. But Schuler, like most analysts, is confident that Washington will deliver, just as it has in past financial crises like the savings and loan industry bailout of the late 1980s and early 1990s.

"There may be many things worthy of panic" in the capital markets now, she said, but holding Fannie and Freddie issued securities is "not one of them."

Fannie and Freddie's fast growth and quasi-government status have attracted critics outside the United States before. "Overseas regulators have long had concerns" about the two agencies, said Howard Davies, the former chairman of Britain's market regulator, the Financial Services Authority, and current director of the London School of Economics and Political Science.