naked capitalism

The Wall Street Journal (hat tip Saboor) sends mixed signals in a page one story for tomorrow, “U.S. Mulls Future of Fannie, Freddie.” The Journal reports that contingency planning in case the two GSEs get into trouble has stepped up, yet go to some lengths to take a reassuring tone:

The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply.

These discussions have been going on for months and are part of normal contingency planning that the Treasury Department and other financial regulators regularly undertake. The talks have become more serious recently given the financial woes of the shareholder-owned, government-chartered companies, whose stability is vital to the functioning of the nation’s housing market, these people say.

The government doesn’t expect the entities to fail and no rescue plan is imminent, these people said. Government officials and market analysts expect both companies will be able to raise large amounts of capital relatively easily. Treasury officials are nonetheless talking about what the government could — or should — do if Fannie and Freddie become so pressed that they are unable to borrow money and continue operating.

Contrast the “Oh we’re planning for a disaster as a matter of prudence, there’s really nothing to worry about” message with the presentation by Jim Hamilton at the Fed’s Jackson Hole conference last August. Remember, that was during the first acute phase of the credit crunch, when the focus of concern was interbank liquidity and the implosion of the asset backed commercial paper market:

Since 1990, U.S. nominal GDP has increased about 80% (logarithmically). Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP. The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.3. It is hard to escape the inference that expansion of the role of the GSEs may have had something to do with the expansion of mortgage debt.

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises– about $70 billion last year– represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we’d have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I’m thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, “the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default.” And the Fed says, “oh yes we would.” And the market says, “oh no you wouldn’t.”

It’s a game of chicken. And one thing that’s very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do. That would be an event with significant macroeconomic externalities that the Fed is very much committed to avoid.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks. So here’s my key recommendation– any institution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.

Now instead of following Hamilion’s prescription, the GSEs are increasingly being made one of the preferred vehicles for shoring up the housing market. Freddie and Fannie’s share of US mortgage issuance is 80%, double the level the year prior.

And the Journal downplays signs of increased investor worries:

So far, the companies have been able to tap the credit markets at relatively low cost, despite jitters over their financial condition. On Wednesday, Fannie Mae issued $3 billion in two-year bonds that were priced to yield 3.272%. That was 0.74 percentage point more than yields on comparable Treasury bonds, more than double the gap between those two yields a year ago.

Contrast that paragraph with how Bloomberg described that financing in a story titled “Fannie Mae Pays Record Spreads on Two-Year Note Sale“:

Fannie Mae paid a record yield over benchmark rates on $3 billion of two-year notes amid concern that the U.S. mortgage-finance company doesn’t have enough capital to weather the biggest housing slump since the Great Depression.

The 3.25 percent benchmark notes priced to yield 3.27 percent, or 74 basis points more than comparable U.S. Treasuries, the Washington-based company said today in an e-mailed statement. That’s the biggest spread since Fannie Mae first sold two-year benchmark notes in 2000 and triple what it paid in June 2006.

Investors and traders are overlooking the government’s implied guarantee of Fannie Mae and Freddie Mac debt as credit losses grow. The companies have raised more than $20 billion since December as their combined losses grew to more than $11 billion. Credit-default swaps tied to their $1.45 trillion of AAA rated debt are trading at levels that imply the bonds should be rated A2 by Moody’s Investors Service, according to data compiled by the firm’s credit strategy group.

“There’s tremendous fears in these two,” said Andrew Brenner, co-head of structured products and emerging markets in New York at MF Global Inc. “Look how they’re trading in credit- default swap land.”

Note Bloomberg commented yesterday on the so-called downgrade of Fannie and Freddie in the credit default swaps market.

In fairness, the Journal piece strikes a more concerned tone later in the piece and gives readers the probable denouement:

To continue bolstering the mortgage market, the companies need constant access to the debt markets. If investors suddenly decide they don’t want to buy the companies’ debt, the companies might have to unload some of their holdings, including mortgage-backed securities. Investors have already lost confidence in mortgage-backed securities other than those guaranteed by Fannie, Freddie and the Federal Housing Administration. A dumping of mortgage-backed securities would raise interest rates for people seeking home loans.

The Treasury has been worrying about such a dire scenario for years. In a 2006 speech, Emil Henry, then a Treasury assistant secretary, likened a failure of one of the companies to a “single gunshot setting off an avalanche.”…

There is at least one precedent for the government making concrete a financial obligation that was previously only assumed. During the crisis caused by the failure of savings-and-loan institutions in the 1980s, Congress passed the Competitive Equality Banking Act of 1987, making the government legally liable for obligations of the Federal Deposit Insurance Corp. Congress had previously adopted a joint resolution that the government would support the deposit insurance fund if necessary, but the pledge wasn’t binding.