Fannie and Freddie in dysfunctional credit markets

Author: David Kotok, Post Date: December 6, 2007
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We expected the foreclosure, subprime mess to become the central focal point of US politics; it has now done so.

The reason is simple. A single foreclosure on a street impacts the entire population of the street not just the household that lost their home. All nearby property values are hurt. Foreclosures are an indicator of a much larger cohort of trouble.

Half the foreclosures we see are in three states: Florida, Texas and California. You cannot become president of the United States without winning at least two of these three states. Thus we see the presidential race moving to this topic as the premier issue.

Since the peak of adjustable rate mortgage resets is in May 2008, we expect the politics to intensify. Every pol will offer his or her solution as the best. They will blame others for the problem.

They are all shameful. They are reactive and have not been proactive. Now the dysfunctional American political system is trying to play catch up to the dysfunctional credit markets. Such coincidences of timing have ended badly in the past. This is how we get misguided legislative and permanent tax code changes which are launched as temporary solutions. The whole thing is a sad commentary on our system.

And, as we have written twice, the Federal Reserve is held political hostage during this period by the US Senate which will not confirm nor even hold hearings on two nominees for Fed Governor spots let alone a confirmation on a third sitting Governor who is up for reappointment.

Why am I harping on the politics and the threat to the Fed?

There is a fundamental reason. The United States has two nationally franchised mortgage agencies. Fannie Mae and Freddie Mac. They have had their share of troubles as we know. They have cut their dividends and are raising capital through preferred stock issuance into order to strengthen their weakened balance sheets. They are emasculated by the Congressional system that is also one of the main sources of this credit problem. They have a regulator who has no experience in dealing with an asset class that is falling in price. OFHEO price declines are just surfacing in the OFHEO data. What planet are they on?

Note that GSE debt and specifically Fannie and Freddie is held around the world. About $1 trillion is in foreign institutional hands. Those folks are watching our political system fail and they are insecure. The spreads of GSE debt to corresponding treasury debt by maturity have doubled.

The Greenspan Fed was highly critical of the implied guarantee of the federal government when it came to GSE debt. Yet the GSE debt is still held by many institutions and the status of the implied guarantee is unchanged. The GSEs never directly affirm they have it. The documents they issue deny it. The market has believed the guarantee is valid. Why else would Fannie have a credit line with the US Treasury? Fannie hasn’t used it. BUT it is still there.

This is the time to clarify that situation once and for all. Doing so would clear the markets and put the national housing agencies back into the business they were created to handle. Will that happen? Probably not because it requires forward looking proactive political activity. An oxymoron by definition in the United States where the morons get elected to office.

This overhang of implied guarantee vs. credit risk and credit worthiness of GSE debt is a huge issue and is symptomatic of dysfunctional markets

At Cumberland we believe that the Congress will not permit the GSE debt to default. There is no rescue coming for GSE shareholders nor for the employees of the GSEs when it comes to their stock options. But debt holders are not likely to suffer default.

We also believe that the Congress will not clarify this status even though they would serve the credit markets of the world by doing so.

We are willing to hold GSE debt because we believe we will get paid. We add that many state and local jurisdictions also hold GSE debt and use it as legally authorized cash management and portfolio tools. At current spreads, some GSE debt is becoming cheap. Clients of Cumberland will find it in their taxable fixed income accounts. We are selective about the issues and the structure of each security. That detail is very important in making a debt instrument selection.

Were the Fed not political hostage it would be able to speak clearly and with a single voice about the GSE debt status. Furthermore, it could advise on how it views this debt and how institutions can use it as collateral during this financial turmoil period. We do not expect Fed Governors or presidents to compromise their role as public servants. They are people of character and understand the seriousness of their task.

It is the Congress that could make this issue clear for the markets. If GSE is federally guaranteed, say so. If the guarantee is to be phased out, say so. Uncertainty doesn’t help in periods like this.

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