Taiwan dumps Fannie, Freddie -- and Uncle Sam?

By Randall W. Forsyth
Barron's
Friday, October 24, 2008

http://online.barrons.com/article_email/SB122482470725666021-lMyQjAxMDI4...

After Mao drove the Nationalists off the Mainland in 1949, the cry went up among U.S. conservatives, "Who lost China?"

Now Washington might well worry about who lost Taiwan as a major investor in U.S. agency securities as the Republic of China has openly questioned their credit quality -- even after the federal government has committed hundreds of billions of dollars to bail out mortgage giants Fannie Mae and Freddie Mac.

Beyond that, Washington might well worry that other nations also no longer view its agencies -- and now, by extension, the very credit of the United States of America -- beyond question.

Taiwan's financial regulators reportedly have ordered that nation's insurance companies to pare their holdings of the debt and mortgage-backed securities of Fannie Mae, Freddie Mac, and Ginnie Mae securities, according to a report on the Internet site of Asian Investor magazine.

Such an order would be a stunning rebuke to Washington, coming a little more than a month after the federal government effectively nationalized the mortgage giants. Fannie and Freddie last month were placed into conservatorships with the Treasury standing ready to inject up to $100 billion through purchases of preferred shares in the government sponsored enterprises.

As a result, Fannie and Freddie debt has the "effective guarantee" of the U.S. government, a spokeswoman for the Federal Housing Finance agency, the regulator for the GSEs, said Thursday. (That was a "clarification" of FHFA director James Lockhart's earlier declaration to the Senate Finance Committee that Fannie and Freddie debt had the "explicit" guarantee of the U.S. Treasury, Dow Jones Newswires reports.)

Moreover, Ginnie Mae securities have always been backed with the same full faith and credit guarantee as the U.S. Treasury.

In either case, the Taiwanese action is a blow to the reeling U.S. mortgage market, which has been supported by the Republic of China's purchases of agency securities. According to U.S. Treasury data, Taiwan owned a very substantial $55 billion of U.S. agencies along with $43 billion of Treasuries as of June 30, 2007, the most recent date for which these data are available.

In mid-July, Treasury Secretary Henry Paulson announced plans to back Fannie and Freddie, which were effected in early September. Indeed, the federal government's actions were in no small part to reassure foreign holders of GSE paper, who had come to trust in its implicit guarantee of the U.S. government. Failure to back Fannie and Freddie would almost certainly have had catastrophic implications for the dollar and all U.S. financial assets.

Yet, as more recent Treasury International Capital numbers show, investors around the globe have been shedding U.S. agency securities since mid-year. The latest TIC data show some $79.4 billion of agencies were liquidated in July and August by investors abroad while they added $69.1 billion to their holdings of Treasuries.

Despite those actions to prop up the GSEs, yields on Fannie and Freddie debt securities have continued to rise to record spreads over Treasuries. Two-year Fannie notes were yielding almost 140 basis points (1.40 percentage points) over Treasuries while 10-year Freddie notes traded 95 basis points over the corresponding Treasury note. Those extraordinary yield premiums for what are, de facto, U.S. government obligations.

The deterioration in Fannie and Freddie securities' prices, resulting in part from the liquidation from abroad, has hit foreign holders hard.

"Exposures to U.S. agency MBS have created massive holes in Taiwanese insurers' balance sheets," according to Asian Investor. As a result, the FSC has eased requirements for MBS to be marked to market.

At the same time, the Insurance Bureau at the Financial Supervisory Commission in Taipei revised rules for the treatment capped allowable exposure for mortgage-backed securities, although the regulators stopped short of ordering their outright sale.

Perhaps something was lost in translation of the housing bill that provided for the Fannie-Freddie bailout.

In the U.S., the $130 billion Pimco Total Return Bond fund -- the world's biggest fixed-income fund, run by Barron's Roundtable member Bill Gross -- boosted its holdings of MBS (primarily Fannies and Freddies) to 79% by the end of September. That was the highest since June 2000 and an increase from 69% at the end of September. DJ Newswires quoted a Pimco manager this week that he continues to favor agency MBS and direct debt, precisely because of the federal backing of the securities.

On the other hand, distance may have provided a different perspective. Gross had argued forcefully for the U.S. government to use its own balance sheet to fight the credit crisis. And his portfolios of agency MBS and notes rallied when Washington followed his advice.

Taiwan, by contrast, perhaps sees things differently. As a small island with few friends, the ROC has to look out for its own interest. The irony is that America is one of those few allies. If Taiwan implicitly says it doesn't trust the credit of the U.S., what does it say about it say about that nation's faith in Washington in other spheres?

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