Economic & Market Update: July 21, 2008

“Fannie, Freddie & Oil”

Chip Norton, Managing Director of Fixed Income & Economic Analysis

Last Week’s Highlights:

Bailout   de jour:              Freddie and Fannie stable

Stocks:                              Dow still rebounds

Bonds:                               Yields back above 4%

Oil:                                     From record to retreat

Dollar:                               Showing strength

Economics This Week:

Date      Item                                  Est.                     Comment

7/24      Existing Home Sales     4.95m                     Unchanged seen

7/25      Durable Goods                  0.1%                    Small lift expected

7/25      New Home Sales              505k                    Small decline again

What a week will make in the life of the market! This time last week, the markets were facing oil at record highs and the possible insolvency of Freddie and Fannie. As we open this week, oil prices have made a monumental retreat back to $124 as the “oil trade” appears to have peaked – for the moment. I say oil trade because it’s this observer’s opinion that the move from $146 to $128 today is nothing more than a simple profit taking top.

Once the market got wind that the President was finally ready to open up offshore drilling, the fear factor that oil supplies would be always be behind demand seemed to dissipate; that’s all it took for those commodities traders who have booked 50% gains in the last four months to decide to pull some profit off the table. One might say this is a simplistic answer as to why oil pulled back given all of the world-wide geopolitical issues that have surrounded the situation. However, not much else has changed fundamentally.

OPEC is not pumping more oil, no new reserves has been opened, tension in the Middle-East has not declined, etc, etc, etc.  So, for the moment, we all might get a break as energy analysts suggest this will quickly bring gas back below $4 and take some pressure off the inflation front – all good things for the economy and for the markets.  Does this mean we are somehow out of the woods? Certainly not. A correction is just a correction – no matter what commodity or security it may be.  This price dip in crude could just as easily been seen as a buying opportunity in the weeks or months to come, but at least we all know now that oil, as crude as it is, is not invincible.

Fannie & Freddie- Too Chinese To Fail

There have been series of great articles in circulation post the Freddie and Fannie near disaster. One of the most interesting topics is the one that points to the underlying ownership of Freddie and Fannie.  While the stock of these two GSE giants has been pummeled (although, big rebounds last week), the debt side has been relatively stable.  And of course it should given the implicit guarantee of the US government and the very strong statement from Secretary Paulson and Fed Chairman Bernanke last week. But did you know that the true owners of Freddie and Fannie are the Chinese and the Russians?

In an article published last week on Dealbreaker.com, their editors indicate that, "China, according to the US data, has $422 billion of long-term Agency bonds. That is roughly 10% of China’s GDP. Based on the pattern of revisions in past surveys and the scale of China’s foreign asset growth, I would guess that China now holds between $500 and $600b of Agencies — or about 10% of the outstanding stock.

Russia, according to the US data, holds $90 billion of long-term Agencies. Russia also has a large portfolio of short-term Agency bonds (with a maturity of less than a year). That brings Russia’s total holdings of Agencies up to $156 billion — or roughly 10% of Russia’s GDP (a bit more actually).” There is some debate as to the accuracy of the data due to the way foreign ownership is reported but even if it were off by a large amount, the impact and the importance wouldn’t be diminished.

Source: Dealbreaker.com

So why is this so important? Do you think the efforts of the Treasury, the Fed and the Administration were just to save the housing market last week? One just might speculate that there is a much broader agenda in progress, that is, to secure the ability of the US to ultimately finance its debt via international buyers. If Freddie and/or Fannie had become insolvent, it would have been very difficult for the US to fund its deficits. If Asian market buyers believed their GSE bonds were being relegated to corporate bond status rather than sovereign backing, the appeal of “US” debt could easily be lost. A big weighty issue for sure-one that is critically important to the US economy.

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