Fannie, Freddie bailout would imperil budget, dollar

NEW YORK (Reuters) - Fannie Mae and Freddie Mac's rapid slide into the center of the global financial crisis has Wall Street frantically talking about a possible government takeover of the government-sponsored mortgage agencies.

But many also worry that a bailout of the GSEs would be so costly that it would cripple the budget and threaten an already badly bruised U.S. currency.

"A perception that the U.S. is no longer a safe haven for capital could produce tremendous strain on the dollar, as would fears of ballooning Treasury commitments associated with a bailout," said James Hamilton, economics professor at the University of California, San Diego.

Together, Fannie and Freddie control nearly half the U.S. mortgage market. The slide in the companies' publicly traded shares has been staggering. Fannie Mae's stock has lost most of its value, swooning from peaks around $70 in August of last year to their current $9.

Freddie has fared even worse. Its shares fell Friday morning to the price of a gallon of gasoline.

Things have become so dire that according to a report in the New York Times, senior Bush administration officials are considering a full-on government takeover.

Treasury Secretary Henry Paulson played down that prospect on Friday, but markets took little comfort in his comments, and the situation remained fluid enough that many are still counting on an eventual bailout.

BLUEPRINT FOR A DOLLAR CRISIS

Such a bold step, unprecedented in scale, would not come without risks. For one thing, the absorption of Fannie and Freddie's liabilities would effectively double the public debt, leaving it at a hefty 65 percent of the gross domestic product.

This could lead to another bout of dollar selling, analysts say, putting an end to the currency's relative calm over the past quarter.

"What is at stake here? The dollar," said Michael Cheah, senior portfolio manager at SunAmerica Asset Management in Jersey City.

A renewed aversion to the greenback, in turn, might revive an old source of anxiety that has so far managed to stay out of the crisis spotlight: the possibility that foreign investors might begin to think twice about holding U.S. government debt.

Overseas central banks own over a quarter of marketable Treasury bonds, and nearly $1 trillion in agency debt.

Standard & Poor's has said the GSEs pose a far greater risk than broker-dealers to the government's AAA credit rating. An S&P analyst also said on Friday that while a Fannie/Freddie downgrade would not necessarily affect the U.S. sovereign debt grade, more generalized problems in the financial sector could.

A run on the dollar would also exacerbate rising inflation, led most visibly by record oil and commodity prices. Reuters/University of Michigan data showed yet another spike in one-year inflation expectations, which climbed to 5.3 percent in July from 5.1 percent in June.

For many investors, this issue is not as pressing as the immediate need to put a floor under the housing market's free-fall. Some argue the dollar's boost to exports provides a counterweight to all the gloom, helping to rein in the trade gap responsible for the currency's weakness.

"We think the biggest part of the decline is well behind us," said Thomas Higgins, chief economist at Payden & Rygel in Los Angeles. "We'll see the dollar bottom at some point this year."

IT ALL HAPPENED SO QUICKLY

Nonetheless, the breathtaking speed at which the week's developments seemed to spiral out of control is a testament to just how skittish markets have become.

"What happened? From just Monday to Thursday all of a sudden we're (talking about) bailing out the GSEs," said Kevin Logan, senior U.S. economist at Dresdner Kleinwort in New York.

Wall Street's concerns first surfaced after a pair of investment notes raised the possibility that accounting rule changes could force Fannie Mae and Freddie Mac to raise $75 billion, a tall task given turbulent market conditions.

Former St. Louis Federal Reserve President William Poole added fuel to the fire, telling Bloomberg News in an interview that Fannie and Freddie were "insolvent" and might require a government bailout.

Yet it soon became clear that something bigger was going on. Fannie and Freddie will very likely be exempted from any accounting overhaul, and investors take comfort in the federal government's backing.

"At the end of the day they'll be truly government supported in every which way," said Thomas Di Galoma, head of government bond trading at Jefferies.

That may very well be the case. But given the fragile state of global financial markets -- and the sheer magnitude of a potential bailout -- the possibility of a dollar crisis is difficult to dismiss out of hand.

The steady pillar of government support suddenly seems less sturdy.

(Additional reporting by Burton Frierson; Editing by Dan Grebler)