17 September 2008

Fannie & Freddie - Holding Back The Tide!

* by Satyajit Das
* September 15, 2008

The US Treasury's "rescue" package for the Federal National Mortgage Association ("FNMA" or Fannie Mae) and the Federal Home Loan Mortgage Corporation ("FHLMC" or Freddie Mac") (collectively the "Agencies" or Government Sponsored Enterprises ("GSEs")) elicited a spectacular reaction from financial markets. In a triumph of hope over experience, markets betrayed their essential "romanticism". As John Maynard Keynes observed: "It is necessarily part of the business of a banker to profess a conventional respectability which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men."

The Fannie and Freddie show had all the staged, stylised and utterly predictable drama of Japanese Kabuki theatre. Confusion over objectives, aggressive expansion, increased risk taking, inadequate capital, (sometimes) controversial accounting and frequent political interference led to entirely predictable financial problems and ultimately the inevitable government "bailout". In July 2008, one US newspaper accurately predicted the denouement in a prophetic headline: "Fannie et Freddie est fini!"

Established by the US government and then subsequently privatised (Fannie Mae was sold into private ownership by the Johnson administration to help finance the Vietnam War), successive administrations have used the GSEs to create liquidity and support the financial system in times of stress. In 1994, the GSEs expanded their balance sheets (chiefly holdings of mortgages and mortgage backed securities ("MBS")) by US$150 billion (double the previous year's expansion) to reduce the effect of the bond market collapse. GSE balance sheets expanded in the period 1998 to 2001 in response to the Asian monetary crisis, Russian default, LTCM collapse and end of the Internet and Telecom boom: US $305 billion (1998); $317 billion (1999), US$ 238 billion (2000) and US $344 billion (2001). Since 2007, the US government has used Fannie and Freddie to increase mortgage lending to help ameliorate the effects of the sub-prime mortgage crisis.

Under the bailout proposal, the government will commit to purchase (up to) US$ 100 billion in 10% coupon preferred stocks in the company consisting of an initial commitment of US$1 billion and warrants for 79.9% of common stock. The aim is to maintain positive net worth of the entities. The government will also provide funding to Fannie and Freddie secured against MBS issued by the GSEs and the Federal Home Loan Banks ("FHLB"). The structure of the support package avoids "ambiguities in the GSE Congressional charters" and benefiting shareholders.

The plan falls short of a full faith unconditional U.S. government guarantee of GSE obligations. There are advantages tactical advantages in this arrangement. Continuation of Freddie and Fannie as "implicitly" but not "explicitly" guaranteed entities creates a cover of "plausible deniability" for the US to pay higher costs on its borrowings without increasing the cost of Treasury bonds.

The government actions benefitted Fannie and Freddie senior debt holders as credit spreads on the bonds tightened due the US Treasury support. Credit spreads on Fannie and Freddie decreased to 38 basis points (0.38% pa) on 5 September 2008 from around 80 basis points (0.80% pa) in July 2008. PIMCO, the asset manager, reputedly recorded a gain of US$ 1.7 billion. Bill Gross, co-founder of PIMCO, has been one of principal advocates of a government rescue of the troubled GSEs.

Subordinated debt holders also receive a "get out of jail" card as the proposals cover these obligations. Fannie subordinated debt credit spreads fell to 233 basis points (2.33 % pa) on 5 September 2008 from 364 basis points (3.64% pa) on 20 August 20008. Subordinated debt is normally treated as equity or near equity and would not normally have benefited.

Common and preferred stock holders suffer through dilution and the suspension of dividends. Under the conservatorship, the GSEs are to be managed to meet their obligations rather maximise shareholder returns. The common and preferred stock rank effectively last in terms of claims on the assets. It is difficult to see a significant recovery in the value of these securities in the near term.

The government actions address the supply of housing finance. As the US mortgage crisis developed, private label mortgage securitisation fell sharply. As at end August 2008, asset-sacked securities ("ABS") issuance year-to-date in the US was down 73% on 2007. CDO issuance was down 90% and home equity ABS issuance was insignificant. The grand mal seizure in securitisation means that the availability of non-GSE mortgage finance has become extremely restricted. The U.S. Administration loosened capital controls, promoted additional lending and encouraged GSE purchases of MBS in order to support the mortgage market. A failure of Fannie and Freddie would have exacerbated the deep seated problems in the housing market.

The US also needs to maintain financial credibility with investors, especially international investors. Foreign demand for GSE bonds and (to a lesser extent) US Treasury bonds has weakened in recent times. Low nominal (negative real) interest rates and dollar weakness are key factors.

Foreign investors are also beginning to question the credibility of the Federal Reserve and US Treasury. Foreign investors, including more than 60 global central banks, hold over $1,400 billion in securities of US agencies including Fannie Mae and Freddie Mac. Chinese investors alone own around US$500 billion of GSE debt.

On 23 July 2008, the Financial Times, reported that the US embassy called the Kuwait Investment Authority ("KIA"), the world's sixth-biggest sovereign wealth fund, to reassure them about the "soundness" of bonds issued by Fannie Mae and Freddie Mac after Kuwait's minister of finance announced that the KIA was not planning to invest in their debt in future. Yu Yongding, an influential Chinese economist and former advisor to China's central bank, recently warned that: "If the US government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it's not the end of the world, it is the end of the current international financial system." Pressure from key foreign investors forced the US government to act order to ensure essential access to international capital.

Markets and some commentators interpreted the government actions as a major step in the resolution of the current financial crisis. There are reasons for caution.

The actions, at best, stabilise the supply of mortgage credit in the US. Future activity of the GSEs will be restricted limiting supply of mortgage finance. Government support may help reduce the stubbornly high cost of mortgage finance despite cuts totaling 3.25% in the Federal Funds rate.

The proposals are not permanent. Withdrawal of support by future administrations and Congress although unlikely cannot be completely discounted.

The US$ 100 billion commitment equates to less than 2 % of the US$5.4 trillion GSE portfolio of mortgages and guarantees. If existing capital (around US$80 billion) is taken into account this improves to around 3%. Given rising default rates and the poor outlook of the housing market, the capital injection may not be sufficient to ensure solvency.

The GSE MBS investment portfolio (around US$1.4 trillion which will modestly increase through to the end of 2009) will be gradually reduced after 2010 at the rate of 10 % per year to $250 billion each, or $500 billion total. The US Treasury assumes that the reduction in GSE portfolio size will be through natural run off.

The Federal Reserve also holds MBS securities (over US$ 400 billion) as collateral for loans to financial institutions under various liquidity support arrangements. The overhang of these securities may affect MBS prices and activity. If credit conditions do not improve over the next 18 months, then the divestment of this portfolio may cause market dislocation, as the GSEs become users rather than suppliers of liquidity to the mortgage market.

Banks and insurers own a significant amount of the US$36 billion in outstanding preferred stock in Fannie and Freddie. JP Morgan has warned of a possible US$600 million loss on its US$ 1.2 billion investment. Federal banking agencies believe that only a limited number of smaller institutions have holdings that are significant compared to their capital. Given the fragile capital positions of many institutions, the losses create additional pressure to raise additional equity or reduce the size of balance sheets compounding the contraction of credit.

The problems and bailout of Fannie and Freddie indicate the severity of the problems facing the US and global financial system.

The problems at the GSEs indicate that the mortgage market generally, especially higher credit quality (prime and Alt A) mortgages, has deteriorated as the US economy slows, unemployment rises, availability of credit/ refinancing reduces and houses prices decline. The GSE rescue may presage further bank write-offs.

The banking system requires new capital to cover losses and involuntary asset growth (returning "off balance sheet" assets previously held in the "shadow banking system" (Collateralised Debt Obligations ("CDOs"), ABS, Structured Investment Vehicles ("SIV") and hedge funds)). The government bailout comes after the failure of the search for a buyer or major equity investor to recapitalise the GSEs. The reluctance of the usual suspects - sovereign wealth funds and Chinese Banks - to act as the "sugar daddy" does not augur well for future capital raising by financial institutions.

Credit default swaps ("CDS") on Freddie and Fannie (a form of credit insurance) have been triggered as a result of the conservatorship necessitating settlement of around US$500 billion to US$1,000 billion in contracts. Expected losses are unknown. Initial expectations were that they will not be significant as Fannie and Freddie debt would now trade around face value or 100%. However, even at a trading level of 95%, the losses would total US$25 billion onUS$500 billion in contracts.

Settlement of the CDS contracts may limit any decline in credit spreads on GSE debt. Government support for GSE subordinated debt appears to be designed to avoid the possibility of triggering large losses on CDS contracts. At a minimum, settlement of the CDS contract will impede progress on restructuring Fannie and Freddie. It also poses questions on the effectiveness of CDS contracts in transferring risk of default generally.

The GSE saga exposes systemic problems for the United State. The size of bailout and the ultimate cost to the US taxpayer is difficult to quantify. Henry Paulson did not mince words on CNBC on the cost of the rescue: "We didn't sit there and figure this out with a calculator."

The commitment of the US treasury is US$100 billion. This compares to the US$ 250 billion cost (in current dollars) of the Savings and Loan industry in the 1980s.

This does not include funding under the secured credit facility. The amount is unspecified but may be up to the US$1.4 trillion MBS portfolio held by the GSE that can be pledged as collateral. When added to US$400 of funding provided by the Federal Reserve to the financial system, the sums involved are not trivial.

The US authorities argue that the risk of loss is low because the loans are secured against high quality ABS securities. Based on the price of similar securities in actual transactions (e.g. Merrill Lynch's sale of a portfolio to Lone Star), current market values may be below levels assumed by the central bankers. The authorities may have to hold the securities to maturity and allow the underlying cash flows to repay their loans. The risk of actual losses cannot be entirely discounted.

There may also be other claims on the government. The Federal Home Loan Banks have expanded their lending and may need more capital. FDIC funding of around US$ 45 billion may be inadequate to meet demands from bank failures requiring additional government funding.

Non-financial parts of the economy, the car makers and the perennially troubled airline industry, may also require government support.

The US government's financial flexibility in meeting increased demands for funding is restricted as the budget deficit is already high and likely to worsen with falling tax revenues. After the GSE bailout, US Treasury bonds fell in price as interest rates rose anticipating the need for the US Treasury to increase issuance to finance its requirements.

The GSE debt problem has been transformed into a US national debt problem. The US has total private debt of US$4.7 trillion of which US$2.4 trillion (51%) is held by foreign investors. The GSE takeover adds around US$5.4 trillion in debt and guarantees, of which around US$1.4 trillion is owned by foreigners.

The increase may ultimately affect the ability of the US to finance its budget deficit and trade deficit. It may also affect the USA's AAA credit rating although the rating agencies have indicated that a re-rating is not eminent. A reassessment would threaten the status of the US dollar as the pre-eminent world major reserve currency.

A complete meltdown has been avoided temporarily. Equity markets and the US dollar rose sharply in response to the plan. The recovery in equity markets has not been sustained consistent with the reaction of the markets to previous government interventions over the last 18 months. As John Kenneth Galbraith noted: "In economics, hope and faith coexist with great scientific pretension".

Some stability has returned to the market for GSE debt. On 9 September 2008, Fannie Mae sold US$ 7 billion of two year bonds at a spread of 70 basis points (0.70% pa) over comparable Treasuries. The cost was lower relative to similar bond sales the previous month. Orders totaled more than US$9 billion and after the sale the spread tightened to 66bp (0.66% pa). Domestic investors bought most of the new notes. Foreign buyers purchase 37 % of the sale, below their typical participation rate of 50%. Asian investors purchased 12 % of the notes below the 39 % of Fannie's last sale of two-year notes in July.

Treasury Secretary Henry Paulson told Congess in July: "If you've got a bazooka, and people know you've got it, you may not have to take it out." Implicit authority and threat of action is much more powerful than the actual exercise of authority that only exposes the limits of power. The fact that Paulson had take out the bazooka but also fire it highlights the depth of the problems and how compromised US power has become.

The problems at the two GSEs, the need for recapitalisation and the reduction in leverage are symptomatic of the significant de-leveraging that is under way in the financial system. Adjustment in the level of debt and asset prices is part of process of "creative destruction" through which the global financial system re-establishes itself.

Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. Like King Canute, central bankers and ministers cannot hold back the tide.


Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

1 comment:

Patrick Roberts said...

it's hard to object to the government's mass bailouts as similar debt-producing methods were put into action to bring the U.S. out of the Depression... our economy has been supported and driven by debt ever since