Yes, it’s the end of the summer, but the Fed boys worked over the weekend, so what’s the excuse of Hank Paulson & Co.? The saber rattling for the Fannie and Freddie rescue program to be unveiled is getting louder and louder.
We had an unmistakable demand from the Chinese over the weekend, if you somehow managed to miss it: From Bloomberg:
A failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system, said Yu Yongding, a former adviser to China’s central bank.
“If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,” Yu said in e-mailed answers to questions yesterday. “If it is not the end of the world, it is the end of the current international financial system.”
You can’t say we weren’t warned.
Politer reminders came from some US financial heavyweights today, as Reuters tells us:
Two of the biggest U.S. bond investors said they would get involved in a capital raising by Fannie Mae and Freddie Mac as long as the U.S. Treasury participates in the new deals.
But Bill Gross, chief investment officer at Pacific Investment Management Co., and Dan Fuss, vice chairman of Boston-based Loomis Sayles, disagree on what shape any deal with Treasury should take, according to separate interviews on Friday.
Gross would be drawn to a straight preferred stock offering similar to securities sold by Fannie Mae and Freddie Mac in raising capital this year and last, while Fuss wants an offering of convertible debentures.
The real point of these statements was to remind the Fed that folks like Pimco and Loomis Sayles were going to sit on their hands until the Treasury unveils its program. Well, perhaps not entirely. Freddie’s note sales today were reported to have gone well, but at higher spreads than last week, so one has to quibble with that characterization a bit.
And John Jensen tells us that the mood in the markets is lousy:
Prices of Treasury coupon securities surged today as the credit crunch hovers and associated economic weakness hangs over the market like a funeral pall draped over a casket. It is sad and depressing and good news is hard to find.The day opened with the news that there would not be a Korean based deus ex machina for Lehman Brothers. The strange euphoria which this shabby story generated faded quickly.
During the day the depth of the problem resonated with word that JPMorgan in an SEC filing has acknowledged that it had lost $1.2 billion in write downs on FNMA and Freddie Mac preferred stock. If they are down that much what is the fate of regional banks with less capital and a far larger (percentage) holding than JPM.
It’s now no mystery that crafting a deal won’t be trivial (gee, you think they might have looked into what their little plan might entail before getting themselves and Congress committed to it. But then again, this is the Administration that occupied a Middle Eastern nation with pretty much no post war plans, apparently not even any civil affairs units).
Leaving the GSEs to their own devices is no longer an option; no one is going to pony up new equity, given the high odds that any investment by the government will wipe out or at least damage current shareholders. The Treasury would love to take out both the preferred and common equity holders, but too many banks, like JP Morgan, own preferred, and the last thing it wants to do is further weaken bank balance sheets. We’ve noted that the easiest-to-implement option would be for Treasury to bid for GSE debt when and if needed, but that’s a solution that the markets are likely to deem a mere stop-gap.
There is even lack of agreement as to what the government’s posture should be. The Administration could make a significant commitment to help the GSEs support the housing market. But with further losses in the offing, that step looks risky (funny how shifting a commitment from a contingent liability to on balance sheet changes one’s perspective). And with fall campaigns about to gear up, there seems to be some reluctance to take big moves (odd, that doesn’t seem to inhibit the Adminstration from a keeping up war of words with Iran, or unilaterally abrogating the ABM treaty).
In case you doubt a rescue is necessary, consider the words of Financial Times columnist John Dizard:
Fannie Mae and Freddie Mac need to be nationalised, in the sense that the federal government injects capital in the form of preferred equity and direct credit support, wiping out the existing common. I believe it is critical that that takeover leaves the privately held preferred stock of the government-sponsored enterprises in place. Preserving the value of GSE preferred issues is very much in the taxpayers’ interest, as it makes possible the recapitalisation of the rest of the banking system.
Most of the discussion of the need for a federal takeover of the GSEs has concerned their credit losses on subprime and Alt-A paper. However, even if a private recapitalisation could be done to offset those, the GSEs would not have sufficient capital to handle the long-term risk of the maturity mismatches on their highly leveraged balance sheet.
Let’s say there’s a great economic recovery, housing prices stabilise, and the interest rate curve becomes more normal. The rise in long-term rates would lead to an extension of the maturity of mortgage portfolios, which would need to be offset by hedging activities. Significant declines in the long end would also need to be hedged, as homeowners refinanced. I don’t believe the interest rate swaps market will have the capacity or willingness to take on that risk at any payable price. One way or another, these institutions will spend a considerable time with negative equity. Again. The only way to handle that is with government ownership.
No doubt there are bankers and lawyers explaining all this to the Washington “leadership”, in the respectful, but urgent, tones trust and estate lawyers use when telling dim heirs that they need to sign a document lest Mummy’s bequest become valueless. It could take a little while for the political managers to accept that they need to shred yet another set of talking points.