Fannie and Freddie

Author: David Kotok, Post Date: July 11, 2008

Let’s try to sculpt some of the fog swirling around the Fannie Mae and Freddie Mac (F&F) issues.  First some facts:

1. Under present rules the Fed is already specifically authorized to purchase F&F debt for its own account. view history No change in rule or law is needed.  As of the most recent Fed Reserve report (Thursday, July 10) the Fed’s holdings were zero.

2. The Fed already accepts F&F as collateral for Discount Window lending and TAF lending.  The same is true for all the debt of any of the Government Sponsored Enterprises (GSE).

3. The Fed does not lend directly to F&F at the present time.  F&F are not primary dealers.  For a list of the primary dealers, look at the NY Fed website.  You will not see F&F.

4. The Fed could make F&F a primary dealer at any time.  It can invoke the same emergency power that it used in the Bear Stearns transaction and in the subsequent authorization of direct lending to the remaining primary dealers.  At the moment the Fed has no reason to do this.  F&F are not important agents for the Fed when it engages in open-market operations.

Now we offer some opinions:

F&F will not be allowed to default on their direct outstanding debt.  The systemic destruction would be global and enormous.  F&F paper is held by institutions worldwide.  And it is a legal investment and holding for nearly all state and local governments in the United States.

Equally true is the status of the debt that F&F has guaranteed.  The government will not permit default on the mortgage-related securities pooled and then resold with an F&F guarantee.  Furthermore, there is no imminent threat of default.  The payment stream from the more than $5 trillion of mortgages is mostly current and has a reasonably good performance history.  In addition, F&F are functioning agencies.  They have liquidity and market access.  Default by F&F is very unlikely.  Those who compare F&F to IndyMac’s seizure are mistaken.

Solvency and the need for capital is another issue.  If one puts the guaranteed mortgages on the balance sheets of F&F, they will have absolute and certain capital inadequacy.  The estimates vary but seem to center at about $50 billion.  F&F face an impossible task if they have to raise that amount by conventional means in this market climate and with the intensely negative sentiment circulating about them.  Their capital is thin to start with although it is conforming in accordance with the rules of their federal regulator.  The now infamous accounting rule change would render them technically insolvent, as former St. Louis Fed President Bill Poole correctly contends.

In sum, we are not worried about a default in F&F debt.  We hold positions in mortgages guaranteed by F&F and some small positions in their debentures and notes.  The widening of credit spreads on all GSEs has made them attractive for certain portfolios.

Common shares of F&F are another matter.  We value them at near zero.  In the Bear Stearns event we saw affirmation that the federal government had no sympathy for equity investors even as it preserved the rights of debt holders and counterparties.  We believe the same is true for F&F.  The stock market thinks so, too.  That is why the equity value of F&F has been decimated.  We have avoided F&F shares and have been selective in the use of broad ETFs where they are part of a large assemblage of stocks

The preferred shares are a tougher issue for investors.  They are trading at about 70 cents on the dollar in a thin market.  We believe they are at risk if some restructuring of F&F is undertaken by the federal authorities.  The balance sheet construction and the concept of a preferred are clear, and investors should not be deluded into thinking otherwise. 

A restructuring of F&F could take many forms.  Some of the possibilities would eliminate the claim of to the preferred shareholder. Other forms of reorganization would preserve it.  This outcome is unpredictable. There is risk in this preferred security.

The Fed is not the likely operational vehicle for a restructuring of F&F.  The Fed’s task is to deal with liquidity, not solvency.  The Fed can reliquefy dysfunctional financial markets and is doing so.  It can use its balance sheet to achieve a clearing market in F&F debt if markets seize and cease to function.

F&F are not banks.  They do not experience “runs.”  They should not be compared to Countrywide or Indymac.  Their status of congressionally sponsored federal agencies places them in a unique position and parallel with all other federal agencies.  There is no history of the federal government reneging on its implied promise to pay the debt obligations of a federal agency.  Yesteryear’s S&L crisis and federal deposit insurance issues affirmed this federal obligatory concept. 

Readers may wish to note the list of US federal agencies and other organizations for which the Fed is the paying agent.  They are articulated in a Fed press release: “By law, Reserve Banks act as fiscal agents for these government-sponsored enterprises and international organizations: the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, entities of the Federal Home Loan Bank System, the Farm Credit System, the Federal Agricultural Mortgage Corporation, the Student Loan Marketing Association, the International Bank for Reconstruction and Development (World Bank), the Inter-American Development Bank, the Asian Development Bank, and the African Development Bank.” 

Readers may also note that, until July 2006, the Fed allowed these agencies to obtain daylight overdrafts without cost.  Since July 2006, the Fed has required these agencies to hold balances sufficient to cover those payments.  The Fed affirmed in that 2006 rule change that these agencies do NOT have regular access to the Discount Window.  The Fed operated by its own rulemaking ability and could reverse this decision at any time.

The Fed is not normally in the business of fixing insolvencies, especially those which are created by changes in accounting rules.  These are issues for F&F regulators and for the Congress. 

Readers, please note that I may end up being totally wrong in this statement.  The Fed is now engaged in the extraordinary Maiden Lane, LLC portfolio liquidation project which is the result of the Bear Stearns debacle.  In that case the Fed may (underline the word may) actually face loss of taxpayer funds when that portfolio issue is finally resolved.  Alternatively, the Fed could end up with a profit.  We have no way to know if Maiden Lane becomes the new model of Fed assisted financial engineering in cases like Bear Stearns and others.  We do know that applying that model to F&F would be a monstrous task and one that the Fed certainly would prefer to avoid.

Longtime readers know we have a dim view of Congress.  It is exacerbated by the scandalous and arrogant behavior of the present chairman of the Senate Banking Committee, Christopher Dodd, who still hasn’t admitted his personal failure in taking a VIP mortgage from Countrywide.  That said we believe Dodd and his House counterpart Barney Frank will support Congressional changes that add financial strength to the GSEs.  They are pro-GSE in their politics.

The US Treasury cannot do much other than jawbone regarding F&F.  It takes changes in law to expand the powers for a Treasury intervention.  There is a small credit line with the Treasury that has never been used by the GSEs.  We do not expect it to be used now.  It was originally legislated in order to insure liquidity.  The Fed can and will handle that part.  If a GSE were to draw on a Treasury line now, the action would create a panic far worse than we have seen this week.  Markets would infer that things are even worse than presently believed.  We do not expect F&F to borrow from Treasury.

Finally, the Congress could easily fix this mess and improve the state of housing finance.  The credit spreads between GSE debt and Treasury debt are wide because of the uncertainty.  The government backing of F&F is “implied” and not explicit.  A Congressional guarantee would change that.  Studies of the cost of this Congressional failure suggest that the annual cost of this uncertainty created by the Congress is in the multi-hundred billions.

Furthermore, the guarantee could be limited to existing debt and explicitly avoid guaranteeing any new debt if Congress wanted to phase out F&F as a federal agency.  That would create a two-tiered market; call it old F&F and new F&F.  Alternatively, Congress could extend the guarantee with limits and rules if it wanted to clarify and strengthen F&F.  Either way, Congress could remove the uncertainty premium and that would cause mortgage interest rates to fall and housing finance to become marginally more affordable.  Under these “permanent fix” scenarios, the shareholders of F&F cease to exist and the true federal agency status, without public stockholders, would be restored.  In our view that would be a best outcome for the country.  Federal agencies were not originally intended to enrich private investors and grant stock options to F&F management.  The GNMA program and the veteran’s post WW2 home mortgage lending operations seem to work well in the United States and without all the turmoil created by F&F. 

Detractors of these ideas have argued that the credit rating of the United States would fall below AAA if Congress were to extend this guarantee.  We disagree.  Nearly all of the $5 trillion in mortgages will pay.  And there is large recovery on those mortgages that don’t pay.  Remember, these are not subprime loans.  For the most part they are fully conforming and of fairly high quality. 

But this decisive solution requires political will and political leadership.  Sadly for the financial markets and the country, neither seems visible in July, 2008.

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