FANNIE AND FREDDIE´S BOND MARKET UPHEAVAL/ THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Fannie and Freddie’s bond market upheaval

By James Rickards

Published: August 12 2010 23:43

A strange fog has enveloped the bond market. Once, the strength of a bond was based on the reputation of its issuer. But a change began in 2008, as Fannie Mae and Freddie Mac verged on bankruptcy, and legislation was rushed through the US Congress to restructure them. The political importance of these institutions created a new world, one in which a bond’s performance is determined by the reputation of its holders.

Next week the US Treasury hosts a major conference to discuss Fannie and Freddie’s future. But to understand how they changed the rules, we must return to the circumstances of their restructure. Such things are normally straightforward. Equity is wiped out, assets are revalued and the gap in the balance sheet is uncovered. Bondholders take a “haircut” – meaning a lower than expected return – or a principal reduction. Some principal converts to equity, management is replaced; voilà, life goes on.

But for Fannie and Freddie none of that happened. Both institutions were bankrupt. Today their stock trades at a steep discount, but it still trades. Those who held their debt took no haircut at all. Their assets were never fairly revalued and the balance sheet was replenished with taxpayer funds. Why the different treatment?

One reason is that Russia and China were among the largest holders of Fannie and Freddie bonds. Recall in 2008 that Russian tanks were rolling into Georgia, while the US was utterly dependent on China to purchase its debt. In Moscow a haircut on Fannie or Freddie debt would have been seen as financial warfare. China’s dismay at losing money might have had even more daunting results, given its power to alter the structure of US interest rates at the touch of a keyboard. So, unusually, the identity of the holders, not the condition of the issuer, determined the bond’s fate.

From there the trend continued. In 2009, during the Chrysler bail-out, hedge funds holding Chrysler debt wanted a normal bankruptcy, but were brushed aside by the Obama administration in its rush to accommodate trade union allies. One could have imagined a completely different outcome, if the company in distress had been non-union, or if Chrysler’s bonds had been more heavily owned by union pension funds instead of hedge funds. But the pattern remained, namely that it is the holder’s identity that mattered.

Much the same pattern was seen in Greece, where a rescue came because the debt holders were vulnerable European banks. More typical sovereign debt restructures, as seen in Brazil and Mexico in the 1980s, followed different rules. And while these are just the best-known cases, further examples are not hard to find. Take real estate debt, which is treated differently depending on whether it is owned by a bank or a private fund – largely because banks can raise capital cheaply, courtesy of the Federal Reserve’s close-to-zero interest rates.

This new trend is defended as good policy. We should not, the thinking goes, offend the Russians, or the Chinese. Jobs at Chrysler are worth preserving. European banks must be saved from the threat of a Greek sovereign default. Maybe, but maybe not. For there will be a big price to pay for this kind of outcome by diktat.

Moral hazard is only the most obvious threat. More insidious is what economists call “regime uncertainty”. This ungainly phrase refers not to a political regime, but to laws that allow all players in a market to follow the same rules. Price discovery is difficult in normal markets. But when geopolitics, expediency and short-term concerns overlay them, it is little wonder that equity inflows are drying up, corporations are hoarding cash and mergers and acquisitions have ground to a halt.

Here lies the crux. Policy, whether it be printing money, guarantees or deficit spending, can prop up asset values for a while. This may even be useful in a liquidity crisis. But a solvency crisis is another thing. The longer policy distorts markets by ignoring fundamentals, the longer those reliant on market signals will sit on their hands. The Fed’s recent decision to continue asset purchases shows there is no exit once this path is chosen. As we approach the second anniversary of the Fannie and Freddie bailouts, are we better off? Values cannot recover until they first hit bottom. In short, our economies would be growing more robustly today if we had taken our medicine in 2009.

The writer is a writer, economist, lawyer and investment adviser

Copyright The Financial Times Limited 2010.