It appears as though panic has gripped the investor community regarding Freddie and Fannie. Some investors have been afflicted with selective hearing. Not that we blame them. The media has helped to fuel the panic. Let’s clear the air here.
The first media story which started the ball rolling was a report that former St. Louis Fed President, William Poole stated that he believed that Freddie and Fannie were “insolvent”. Following that announcement, investors began to sell their Fannie and Freddie holdings. What was missed was his comment that the taxpayer would be on the hook for the bailout. He did not say that Freddie and Fannie would not be rescued. What was also missed were comments by Fitch analyst Eileen Fahey that the companies are not insolvent, by Treasury Secretary Paulson that Ofheo informed him that Fannie and Freddie have ample capital and from Ben Bernanke that the GSEs have access to the Fed liquidity programs.
Some market participants became panicked after reading an editorial in today’s Wall Street Journal. The Journal stated that if the U.S. government took responsibility of Freddie’s and Fannie’s combined $5.5 trillion of outstanding mortgages, when combined with the government’s own $9.5 trillion, the government’s AAA rating would be in jeopardy. Reader apparently missed the Journal’s solution to the problem. The Journal states:
“Our own proposal, made months ago, is to require a more honest form of socialism by injecting taxpayer money now into both companies (say, in the form of subordinated debt or preferred stock) to recapitalize them enough to weather the current storm. This would help prevent a U.S. balance sheet debacle, and it would force the politicians to acknowledge the mess they have created. Then as the crisis passed, the taxpayers would at least get something for their money, while regulators could work to unwind Fan and Fred's liabilities and shrink these monsters to a less dangerous size.”
This is in line with my opinion that the government will keep the GSEs from failing, not by placing their debt on its own balance sheet, but by helping the GSEs to weather the storm by ensuring their abilities to raise capital in the capital markets.
This is a good segue into the preferred securities discussion. It is true that there is an implied government guarantee for FNMA and FHLMC debt, but that guarantee does not necessarily extend to their preferred securities. It is possible that in a very dire situation, in which Freddie and Fannie were struggling to service their debt (yes it would have to be that bad), they could suspend preferred dividends. However, let’s look at reality. If the plan to fix the agencies is similar to what the Journal and I believe and new preferreds would be issued, who in the world would invest in preferreds which had their dividend payments in jeopardy from the very beginning. Sure, one is speculating that the dividends will be paid when one invests the GSE preferreds, but given the reality of their situations, wouldn’t investing on many (any) bank and finance preferred is a bigger dividend speculation? We won’t even get into the auto sector or junk bonds in general.
Many investors may be curious just how important the mortgage agencies are to the U.S. economy. Let’s shine a little light mortgages in the U.S. According to many sources, there are approximately $12 trillion of outstanding U.S. mortgages. Of that amount, the GSEs are responsible for about 46%. Throw in GNMA (which carries a full faith guarantee of the U.S. government) and the amount guaranteed by some kind of government agency increases to 70%.
If the mortgage agencies are responsible for 70% of mortgages, who is on the hook for the other 30%? It is mostly investors who hold private label mortgage-backed securities. However, as any mortgage trader or salesperson will tell you, the demand for such securities has waned as investors demand some kind of agency guarantee when investing in mortgage backed securities. If this trend holds true for the foreseeable future, the U.S. housing market may be relying almost completely on the mortgage agencies to provide the necessary mortgage liquidity to encourage a housing recovery. This is why regulators have pushed the GSEs to increase the size of their balance sheets and guarantee larger mortgages. No GSEs would be, not only catastrophic but, possibly, cataclysmic for the U.S. economy.
Disclosure: I am long FREprZ.
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