In Large, Red, Friendly Letters it Reads, “Don’t Panic!” (GSE Edition)
want to tread a fine line this evening. I am going to argue that a government takeover of Fannie and Freddie would not be as costly as some imagine — it would likely be more expensive than the S&L bailout, but not in inflation-adjusted terms. My post is driven by the New York Times article, as cited by Barry Ritholtz, and Yves Smith (as I was drafting this).
The first thing to say is that conservatorship may not happen. The GSEs have many powerful political friends, and they won’t give up without a fight. I rate the odds of conservatorship as less than 50/50 in 2008, and the next President/Congress may have a different opinion.
I want to rule out the idea that the Federal Reserve could save the GSEs. Unlike Bear Stearns, the Fed is too small to materially affect the situation. Sure, it can buy the senior paper of the GSEs, but that would not be enough to absorb more than 10% of the total senior financing base for the GSEs at maximum.
But suppose conservation of Fannie and Freddie takes place. What then?
Most mortgages insured by Fannie and Freddie are good quality already. They financed smaller loans, reasonable down payments, tilted away from the high cost areas that are under the most pressure. For loans prior to 2006, losses should be small. Also, Fannie and Freddie have been careful, even with pressure from politicians.
But some loans were done with mortgage insurance because of low down payments, and the mortgage insurers are in bad shape now. True, and though Fannie and Freddie may not get full payment, they should get 80% payment on the 20% or so of the loan that was insured. Mortgage insurers are worth something, even if not full value. My scenario implies 4% losses on a small portion of their mortgage book.
Now the GSEs will continue to receive guarantee fees, and they still have embedded margins from the loans on their balance sheets. Now, WIlliam Poole says that Freddie is insolvent on a fair value basis, and Fannie might be. Still, the losses are small compared to the S&L bailout at present.
Thus, I argue that a guarantee of senior obligations of the GSEs would not be horrendously costly. Let the preferred and common equity be wiped out. Let the subordinated bondholders sweat. The losses at the senior level should be small.
The benefits of such a guarantee would be big, though. Who invests in Fannie and Freddie direct and guaranteed paper? Banks, insurers, stable value funds, foreign investors, and more. Do we want a “domino effect” that might lead to further financial failures? I think not. Arresting the losses at the senior level, and eventually folding Fannie and Freddie into GNMA preserves many other financial institutions.
Two notes on the politics here: the Bush Administration wins, and loses. Wins, because they end the dominance of the GSEs in a bigger way than they ever could have imagined. Loses, because they can’t use them to support the mortgage market any more. Can the FHLB pick up the slack without them? I doubt it, at least not fully. The FHA isn’t big enough either.
So, be careful here. There are too many variables and political angles to make decisions easy. I think I understand what is most likely here, but I would assume a conservative posture, unless the cost of achieving that posture was too high. We are close to that “too high” level now.
PS — As a bond manager, aside from mortgage bonds, I rarely bought agency bonds because the spreads were too small to bother with. I have a rule for avoiding small bond yield spreads; they are too narrow to waste time over, and the present distress illustrates why. At present a barbell of Treasuries and high yield bonds is more attractive than agencies.
(These are my opinions, and not those of my employer.)
July 11th, 20084:02 am at
Thanks. Very helpful
July 11th, 20087:39 am at
David,
Well, premarket it seems as though the entire world is selling Fannie and Freddie, the stocks are imploding. If you don’t like the equity, what about the CDS? Those spreads are moving out too, as panic sets in.
Really ugly, although it’s probably a case of “this too shall pass”.
Steve
np
July 11th, 200812:36 pm at
Those waterfall charts of FNM, FRE, LEH, WB, DSL, WM, FED, ….
This is what happens when easy money and bailout nation becomes the governing philosophy of crony capitalism. Billion dollar bonuses for Wall Street elites, millions of dollars of contributions to politicians of both parties and of course the revolving door between regulators, policy makers and Wall Street. Rubin, Paulson, Easy Al.
Now the biggest cheerleaders for “free market capitalism” and the repeal of Glass-Steagall and “risk adjusted capital” make even the marxist lenninist communists blush as they scream for nationalization, backstops and bailouts of their losing positions. But those billions in bonuses based on fraudulent financial performance – that’s in the Caymans!
Yes, the shoe is on the other foot!
July 11th, 20082:07 pm at
What are your thoughts on giving BSC COMMON holders $2, but wiping out the preferred holders of a GSE? Yeah, yeah…. there’s the whole ‘moral hazard argument’ – but let’s focus on the financial, rather than the psycho-economic reasoning.
FNM/FRE have $31 billion in preferreds outstanding. I saw one estimate that insurers hold about $7 billion of that, which (if we assume that banks hold the majority of the rest) implies banks could see $20 billion more in hits – ASIDE from other credit costs associated with the loan portfolio.
FNM/FRE preferreds being marked to zero could be the straw that breaks the camel’s back for a number of banks – sending them to the capital markets, only to find that the TRUP window is closed, as are perpetual preferreds. Thus, they will be forced to pay through the nose for debt issuance or issue dilutive common equity.
Either way, I think Steve hit it on the head with one word: ugly.
July 11th, 20083:13 pm at
District Banker — I have stated the same prescription for Bear Stearns in an earlier post. My view is the same for all government bailouts. Protect senior obligations, wipe out common (and maybe preferred), haircuts for things that are in-between (the preferred would fall here with subordinate financing).
I don’t think the government should generally do bailouts, but if they do them, those that took significant risks should not get bailed out. This should look and feel like a last resort, and only be done in cases where the government believes bankruptcy would have large negative spillover effects.
July 12th, 20088:14 pm at
David,
I love reading your balanced views on this mess. No doubt they are much “righter” than mine will ever be.
But … why in the world would any obligations be protected with our tax dollars ? These “geniuses” made their bets … they can doggone well live with the consequences. (realizing that the consequences for us all may be quite unpleasant)
I have no duty to bail anybody out of their (dumb) trades.
July 12th, 200811:27 pm at
David, as usual, an insightful and balanced view. Personally I have an extremely biased view of ANY government bailouts. But here we are.
One way to look at the FNM and FRE is that they are essentially a giant off-balance sheet SIV of the federal government.
The stakes are getting higher and higher. There could be unintended consequences from this. For example, agency bond yield and treasury yield would start to converge w/ treasury yield rising and agency bond spreads compressing. This MAY have the effect of repricing the whole-world’s bond market to the downside. The concept of the risk-free yield and confidence in it would start to shake.
The other issue is the substantial foreign holding of agency debt. One thing that agency debt has been used is in hedged cross-currency carry trades. There are quite a few players would borrow in yen and swiss francs and invest in the USD. Since hedging the currency exposure would offset the benefit of the carry if they invest in Treasuries, these people instead invested in agencies to get into positive carry w/ hedged currency exposure.
The bond, currency, commodities, and equity markets will be extremely treacherous the next couple of weeks.
July 12th, 200811:46 pm at
sysin3, synchro — I have no love for bailouts, or government lending programs… my view is that having Fannie and Freddie in conservation disentangles us from some of the private/public socialism, and would not cost much as a break against a possible “domino effect” should GSE senior obligations weaken.
The private sector would eventually ramp up enough to take the places of the GSEs, and lending rates would rise 0.25%-1.00%. That’s not a bad thing, because it would weed out marginal borrowers. Many people should rent, and the social benefits of private ownership are there, but overstated.