Thursday, September 11, 2008

Bill Gross Makes $1.7 Billion Of Fannie & Freddie Bailout

Tyler Cowen defended the bailout of Fannie & Freddie bond holders by writing that:

"In essence we already agreed to the bail out some time ago. Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car "really meant"? Well, the Chinese spent $340 billion on agency debt and probably asked the same question at least once or twice."

While he is in one sense right that "we" (by which he means the U.S. government) agreed to a bailout by designating Fannie & Freddie government sponsored enterprises and by the informal pledges that those bonds would be safe, it is as some commentators point out something perverse about the fact that these bonds have for a long time (but most particularly in recent months) had a higher yield than Treasuries, yet they are still now supposed to be as safe as Treasuries. Since they have enjoyed higher yields as a risk premium, it is not self-evident that tax payer money should used to completely insulate them from losses. This in fact constitute a massive subsidy of those bond holders, such as the government of China.

Some people argue that the Chinese could threaten to stop buying American securities, but isn't that exactly what the Bush administration and Congressional leaders (both Democrats and Republicans) have claimed to want for a long time? Haven't they always told us how they want the Chinese to stop holding down the value of their currencies by accumulating American securities? Making the Chinese suffer a bit here can perhaps persuade them to stop holding down the value of the yuan, which would the best solution for everyone, at least in the long term.

In a related matter, we can now see why bond fund manager Bill Gross wanted this so much. Apparently, he has in recent months been selling Treasuries and corporate bonds and used the proceeds to buy Fannie & Freddie bonds, while at the same time appearing in the media repeatedly and advocated that the government should bail out owners of Fannie & Freddie bonds, such as himself. Meaning that he can reap the benefit of the higher yields while sending the cost of the defaults he won't be (but should be) affected by. This little arrangement will earn a nice $1.7 billion.

Pretty good deal for him. Not a very good deal for others.


Anonymous maximus said...

A few years ago a bond trader told me that the reason Fannie and Freddie bonds had higher yields than treasuries was due to the call provisions included on them. At that time they were almost always called within a year of issuance. I'm no longer selling bonds to clients so don't know for sure if that reason is still valid, but it makes sense if the agency bonds trade at a higher yield

7:59 AM  

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