Impacts of the Fannie Freddie Bailout On Latin Countries

A perfect storm is brewing over the U.S., and the effects could be devastating for the global economy. To begin with, the recession is starting to take its toll. U.S. corporates are reeling from the reduction in sales, the increase in commodity prices and tighter financial conditions. The three major U.S. automobile companies are slashing output, selling assets and hoarding cash. While their solvency may be assured for the next six months, many people doubt that the three will survive through the end of the decade. GM’s shares, for example, are down 61% since the start of the year. A similar situation is occurring in the financial sector. Federal regulators last week seized IndyMac Bancorp, a California mortgage lender, after a run on the bank left the institution insolvent. Lehman Brothers was also in the crosshairs, with rumors circulating about its imminent demise. The investment bank’s shares plunged almost 80% since the start of the year. However, Freddie Mac and Fannie Mae were the biggest casualties of the week, watching their shares lose half their value on Friday morning as concerns about the state of their balance sheets raised the possibility that they may be nationalized. Such an event would wipe out shareholders, and it could be catastrophic for bondholders. Unfortunately, a meltdown in agency bonds would quickly spread throughout the global financial system. Agency bonds are widely held by private investors, foreign financial institutions and central banks. The latter holds an estimated $925 billion of the AAA assets—with more than half of it in China. Unfortunately, the damage is done. What happens to the bonds is still to be determined, but international investors will be loathe to buy more agency paper—removing a major source of funding for the U.S. Hence, the contraction in U.S. domestic demand will have to accelerate in order to compensate for the reduced access to external financing.

Macro conditions are clearly worsening. Last week, the U.S. suffered the largest employment drop in six years. Non-farm payrolls plunged 79,000, versus expectations of a 20,000 decline. The interesting thing is that the unemployment rate is only 5.5%. However, a deepening of the crisis will push the jobless rate above 8%. This means further deterioration of the housing market. Housing prices fell 15.3% in April, and it could fall another 15% before bottoming out. It is against this backdrop that consumer confidence remained at all time lows. The damage is also spreading to Europe, with a sharp slowdown of economic activity in Spain. Ireland also reported the largest increase in unemployment in more than a decade. The macroeconomic environment affirms that the FOMC will leave interest rates on hold, which pushes most of the monetary adjustment on to the rest of the world. Central banks throughout Latin America and Asia are tightening monetary. Chile recently raised its benchmark rate to 7.25%, marking the highest level in 9 years. The Philippines is expected to follow suit. However, their attempts to stabilize their domestic inflationary pressures will be defeated as long as the Fed abandons all monetary restraint in its desperate attempt to save its defunct financial system.

Although the impact of the crisis on the emerging markets remains restrained, we are entering a dangerous phase. The capital markets are shutting down, and many emerging market corporates and sovereigns will soon face difficulties. Fortunately, the aperture of the capital markets during the second quarter of the year gave many entities an opportunity to reprofile maturities and gain access to financing. However, last week’s turmoil in the agency market could have dire implications for many emerging market financial institutions, which used the AAA instruments as collateral and/or reserves. The impact of the U.S./European economic slowdown on the Asian juggernaut will also be telling. Last week, Chinese authorities released the June trade data. China’s trade surplus shrank 20% y/y, due to higher commodity prices and lower exports. The news was quickly reflect in the Shanghai Composite Index. With the index down 45% since the start of the year and India’s BSE index off 34% during the same time period, much of the optimism in Asia is starting to fade. This could trigger a selloff in the commodity markets, which would be catastrophic for the emerging markets. Therefore, it may be time to run for the hills.

2 Responses to "Impacts of the Fannie Freddie Bailout On Latin Countries"

  1. soros1   July 14, 2008 at 12:59 pm

    Good analysis, Molano. You and Vittoria, though, see the same world from diametrically opposed perspectives, all of which reminds me of Oscar Wilde’s definition of a pessimist— a well-informed optimist. You should write more often.

  2. Anonymous   July 15, 2008 at 2:02 am

    A valuable perspective. I too would like to see you write more often.