The current turmoil of Fannie Mae and Freddie Mac to find substantial capital in order to remain solvent has triggered concerns on how safe that investment is and whether global central banks would start dumping their debts.

As we all know, Fannie & Freddie are government sponsored enterprises that dominate the US housing finance market. They currently guarantee a high fraction of new mortgages in the US.

Without this finance home prices would fall, dragging down the value of a lot of the mortgage-related securities and troubled financial institutions. Hence they are unlikely to fall.

They are no longer just large-cap US financial institutions, they are now global financial institutions that turn US mortgages into securities sold to central banks all over the world.

According to the US Treasury, foreign central banks hold more than $900 billion in agency debt or about 20 percent of the total agency debt outstanding.

In particular, China holds the most agency debt. It is estimated to have about $400 billion, which is approximately 10 percent of China's GDP. If combined with the holdings of Treasuries, the total is close to $1 trillion, approximately 25 percent of the China's GDP and 55 percent of China's foreign reserve.

In a sense, it is a remarkable system for channeling the emerging world's savings into the US housing market.

A system that relied on government's backing in every step, whether the State banks in China, that took in the yuan deposits from Chinese savers and lent those funds to China's central bank which then bought dollars and the agency bonds, or the agencies' ability to use their implicit guarantee to turn US mortgages into fairly liquid reserve assets.

This system works simply because of expectations that the US government would stand behind the agencies and the China government would stand behind the Chinese savers. Hence it allows the US government to turn to the agencies to backstop the mortgage market even in the current credit crisis, as emerging market governments continue to buy huge quantities of agency debts.

However, it seems that this game will break down on the US side before it breaks on the emerging market side as the agencies will run out of equity before central banks lose their willingness to buy agency papers.

Having said that, we do not expect China to panic and start dumping the agency debt. Like most Chinese economic policies, the approach toward reserve diversification will also be gradual.

With more than $1.8 trillion in foreign reserve, China has the ability to sustain the impact of mark-to-market losses.

If the US government manages to push the risk premium on the Fannie & Freddie debt over the US Treasury bonds of similar maturity, the capital gains will be more than enough to cover the current risk.

The author is a director of Convoy Asset Management Limited.

(HK Edition 07/22/2008 page3)