Another day of nervousness and not-exactly-positive developments on the Fannie and Freddie front.
What is remarkable about the situation now is that at least some of the trouble elements were entirely predictable, which suggests that a bit of aforethought might have led to a better plan and less bad outcomes (I’m not such as optimist as to believe that there is a good outcome available. This is an exercise in damage containment).
Let’s look at two elements that were obvious:
1. There was never such a thing as a limited commitment to rescuing Freddie and Fannie. The Administration could have floated a trial balloon on a shared pain option (an idea that Nouriel Roubini suggested, but admitted was just about certain to be a non-starter) of having taxpayers, creditors, and shareholders all take some hits on any Freddie and Fannie losses. But an unspecified commitment to helping the GSEs is tantamount to an open-ended commitment (we likened it to escalation in Vietnam: it may be sold to the public as incremental, but the reality is that it has the potential to be a bottomless pit).
2. Lack of a real program would not work in the long run. Frankly, I am amazed that the Administrations’ hand-waving-in-lieu-of-a-plan worked as long as it has. As we noted:
Treasury Secretary Paulson makes a statement which presents in the vaguest possible terms a plan which falls far short of a remedy for the GSEs. These measures merely serve to stabilize the patient; there is no, zip, nada acknowledgment that major surgery is needed.
Consistent with #2, we learned yesterday that Paulson fantasized that he could simply get some mechanisms in place that might make a certain amount of support for Freddie and Fannie possible, but never use it. That just isn’t going to prove to be sufficient. The GSEs are undercapitalized and need a real program to remedy that, not just empty promises from management (who never took the need for more equity seriously until a gun was put to their head) and the Treasury. But yesterday, we noted at some length, the Administration wasn’t even willing to make the right noises. In fact, the Wall Street Journal reported that the Treasury had hired Morgan Stanley to analyze options for the GSEs. Wasn’t the time for that before legislation was passed?
I suppose the Bushies thought they could kick this can down the road to the next Administration, but that isn’t going to succeed. A five-year Freddie note sale got done at record high spreads over Treasuries. And before you say, “Well, it got done,” one of the rules of Wall Street is almost everything can be solved by price. Illiquidity is often tantamount to “the seller can’t stand the bid,” as opposed to a complete absence of buyers (although there are market free falls when there are no bids or gross order imbalances).
Consider what the Wall Street Journal had to say about the offering:
Freddie Mac was forced to offer unusually rich terms to investors in a $3 billion auction of its debt…The company….had to pay hefty interest rates. The five-year notes were priced to yield 4.172%, or 1.13 percentage point above yields on safe Treasury notes, the highest “spread” Freddie has ever paid on such debt.
John Jansen at Across the Curve gave a more detailed account:
Notwithstanding the relative success of the Freddie sale the agency market is still a very troubled venue. One analyst notes that central bank demand for the sector has diminished significantly since June. He said the change in appetite could not be narrowed down by geography or by the asset size of the institution.
There are some outright sellers, some who just do not add or do not replace as paper rolls off and there is a group of first time buyers. On balance, however, central banks are buying considerably less of this paper.
Some are troubled by the recent statements of Secretary Paulson that he is not eager to use his new powers. Some have extrapolated from his statements that he is only prepared to exercise his powers in an emergency. What constitutes an emergency?
Suppose we walk in tomorrow and Freddie or FNMA can not get rolled over in the discount note market. Treasury exercises its powers and the taxpayers have an ownership interest in the GSEs.
The central banks are anxious for a resolution or some clarification. On the other hand Paulson would probably be happy if the stocks run close to zero and he never has to spend a penny. As long as they open for business each day he is likely to be a contented former partner of Goldman Sachs.
The New York Times reported that crucial foreign interest was flagging:
Even with Freddie Mac’s debt promising investors a rich return, overseas demand for the issuance was weaker than in the past. Asian investors bought about 30 percent of the debt, while Europeans took 10 percent, according to a person familiar with the offering. By comparison, for the 12 months leading up to July, Asian investors accounted for 36 percent of the company’s debt and Europeans held 15 percent, according to data released by Freddie Mac.
And Bloomberg indicated that this pattern showed itself in a previous sale….
Fannie paid a record high yield in a $3.5 billion sale of three-year benchmark notes last week that drew less demand from Asia. Investors in the region bought 22 percent of the offering, almost half the demand of three months ago and about two-thirds of Asia’s usual purchases.
“The 22 percent of Asian participation is worrying,” said Ajay Rajadhyaksha, the head of fixed-income strategy for Barclays Capital in New York.
…and argued that the sizeable funding requirements before the end of the quarter may force a rescue:
Fannie Mae and Freddie Mac’s success in repaying $223 billion of bonds due by the end of the quarter may determine whether they can avoid a federal bailout….
Rolling over the debt “is the single most important factor to their ability to remain liquid,” said Moshe Orenbuch, an analyst at Credit Suisse in New York. “So far, they’ve been able to do that.”…
“This whole backstop mechanism was set up so the actual need for it could be avoided,” said Mahesh Swaminathan, a mortgage strategist for Credit Suisse in New York. “The market is testing the Treasury’s resolve.”
There is a third problem with the Treasury plan which we confess we did not foresee but is blindingly obvious once pointed out. From the Journal:
Meanwhile, Freddie’s ability to raise capital, and therefore avoid a bailout, is constrained by the uncertainty created by the government’s deliberations, according to people familiar with the matter. Investors are unlikely to buy new Freddie shares if they fear the government might mount a rescue that would hurt the value of those shares. Freddie executives are due to meet with Treasury officials Wednesday to discuss the situation and the two sides may explore whether the Treasury could clarify its intentions in a way that would reassure investors.
A rescue, in other words, almost certainly means that equityholders will be wiped out. Thus the company must persuade investors that its capital-raising is sufficiently large so as to preclude a rescue. Given that more losses are certain to be in the offing, it’s well nigh impossible to instill the needed confidence.
One investor interviewed by the New York Times suggested a solution:
Others, including Bert Ely, a financial consultant and long-time critic of the companies, say the best option is for policy makers to buy debt issued by the companies directly. Guaranteeing or buying shares in the companies, by contrast, could expose the government to big losses if more mortgages default.
“In the short term they want to avoid an equity investment, and if they can avoid doing that they will,” Mr. Ely said.
Haven’t we seen a version of that movie over at the Fed?