Deus Ex Macchiato

From Laurie Goodman at Amherst Securities via the Big Picture:

Freddie will likely lose around $178 billion of its $1.86 trillion credit guarantee book, and Fannie will likely lose $270 billion of its $2.81 trillion book. Combine the credit guarantee books of the two firms, and you reach a $4.67 trillion book, with estimated losses at just under 10%, or $448 billion.

My, that is a big number. And of course it suggests that the right capital haircut for residential mortgages is not 4% as per Basel, but rather 8-10%.

Posted in: Basel, Federal Agency, Mortgages by David /
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The big Mac is now not only little, but actually less than nothing. Bloomberg explains.

Posted in: Federal Agency by David /
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Lockhart is an amateur though: he should have waited until Geithner was speaking to announce that Fannie and Freddie may need another $200B. There were some temporary imbalances that made their numbers pretty dramatic he said. Yeah, right.

Posted in: Federal Agency, Mother of all Bailouts by David /
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With rather little fanfare the exceptional high limit for conforming mortgages of $729,750 expired yesterday. The limit is now $625,500 in high cost areas: it remains $417,000 elsewhere. The details are here.

I am surprised this was allowed to happen: I thought that the exception would be extended indefinitely given the state of the US housing market. This cannot be good for California, for instance.

Posted in: Federal Agency, Mortgages by David /
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The highlights of the current new realism:

• Freddie Mac has asked the US government for $13.8B;
• It suffered a record $25.3B quarterly loss and said that shareholders’ equity was a negative $13.7B. So after being bailed out, it will be worth $100M, presumably.
• A significant part of Freddie’s writedowns was $14.3B of deferred tax assets.
• Fannie reported a $29B quarterly loss last week of which $21.4B were deferred tax assets.
• Fannie said it might need more than the $100bn earmarked for each of the two companies in order to stay in business.
• But it does at least claim to have a positive net worth.

Can I say neue sachlichkeit now?

Posted in: Federal Agency, Mother of all Bailouts by David /
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From Bloomberg:

Thirteen “major” dealers of credit-default swaps agreed “unanimously” that the rescue constitutes a credit event triggering payment or delivery of the companies’ bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today.

So the CDS are triggered. What I urgently want to know is is this a termination event on the enormous portfolio of IRD that Fannie and Freddie have as hedges against prepayment risk. Remember these two are amongst the largest players in the interest rate derivatives market, mostly as buyers of convexity. I can’t believe many people want an unwind so the situation should be manageable.

Update. Just in case you are not a regular reader of the components of the major credit indices, it is worth point out that Fannie and Freddie are both in the CDX.

Posted in: CDS and Negative Basis, Federal Agency, Legal Risk and Trade Documentation by David /
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The part of the Fannie and Freddie bailout that worries me is the prefs. From the FDIC:

The federal banking agencies have been assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two government-sponsored enterprises, a limited number of smaller institutions have holdings that are significant compared to their capital.

The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision are prepared to work with these institutions to develop capital-restoration plans pursuant to the capital regulations and the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act.

All institutions are reminded that investments in preferred stock and common stock with readily determinable fair value should be reported as available-for-sale equity security holdings, and that any net unrealized losses on these securities are deducted from regulatory capital.

You’ve got a few hours before the US market opens. Can you figure out who has those holdings that are `significant compared to their capital’ in time for the open?

Update The WSJ says F&F have $36B of prefs outstanding. That’s a chunky loss for the financial system if they really do turn out to be worth basically nothing.

Posted in: Capital and Contingent Instruments, Federal Agency by David /
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There’s nothing really new in the WSJ’s The Fannie & Freddie Question but it is a nice read and it gives some interesting colour on Paulson. I bet he really really wishes it was November.

Posted in: Federal Agency by David /
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Dealbreaker points out a nice trade:

A bank that bought the six month notes from Freddie this morning could also bid to borrow from the Fed’s Term Facility, which held an $75 billion auction today. As collateral for the borrowing, the bank could offer the newly purchased Freddie notes, for which the Fed would give them credit for 97% of their market value. Recently, the TAF pricing topped out at 2.35 percent for 28-day borrowing. So a bank buying $100 million of Freddie paper yielding 2.858% could flip it to the Fed, borrowing $97 million at around 2.4% (assuming the pricing will be slightly higher this time around).

At the end of the day, a credit desk could buy $100 million of Freddie debt for just $3 million down. On that $3 million, the desk would receive a 17.7% annualized return, or 8.8% over six months.

If you believe in the Treasury guarantee of the GSEs, and I think I do, that’s not a bad return.

Posted in: Federal Agency by David /
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Fannie and Freddie fell twenty something percent yesterday as the market digested a report by Barron’s on the state of the Agencies. In practical terms the Barron’s report seems to be pretty much correct: the Agencies will require recapitalisation, and it is unlikely this will be achieved without substantial help from the Treasury. However I do wonder about the timing. As the WSJ pointed out, it all depends on how big Paulson’s balls are:

He can either continue to muddle along and inject a few billion dollars of preferred equity into Fannie and Freddie on an “as needed” basis until the end of the Bush administration in January.

Or he can go full steam ahead with a pre-emptive government takeover of Fannie and Freddie. Ironically, this radical step would make Fannie and Freddie an election issue. And perhaps only that would create momentum for true GSE reform.

The unfortunate reality is that politicians won’t embark voluntarily on a GSE overhaul a few months before an election. It isn’t a vote-winning issue. They would rather throw money at Fannie and Freddie and pray for a housing rebound.

The implication is that we will get piecemeal solutions to keep Fannie and Freddie afloat, just, until after the election rather than full scale reform. I think that’s right. The agencies are going to be the next guy’s problem.

Posted in: Federal Agency by David /
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From a recent Hussman Funds post, Nervous Bunny:

if we include the fair value of preferred equity, we find that on a fair value basis, Fannie Mae is operating at a gross leverage multiple of 72.7 (total assets comprised primarily of mortgage loans, divided by shareholder equity). In other words, a slight 1.4% deterioration in the value of Fannie’s book of assets will wipe out all of the remaining shareholder equity. This makes Long Term Capital Management look like a conservative strategy.

Obviously if we don’t include the prefs, it’s harder to compute the leverage as Fannie has negative equity on a fair value basis. So while Hank might have no plans to put more cash into Fannie and Freddie, it will only take a small fall in their assets before he has to.

Posted in: Capital and Contingent Instruments, Federal Agency by David /
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Bloomberg points out:

The [U.S.] debt limit is $9.815 trillion and the current outstanding public debt subject to that limit is about $9.4 trillion, according to the Treasury.

In other words, actual US borrowing is within $415B of the maximum permitted by Congress. Now while more or less everything I know about the US budget process comes from an episode of the West Wing, it does seem clear that this $400B ceiling limits Hank’s ability to do much meaningful for Freddie and Fannie. And comparing $9.4T with $5T makes the impact of bringing the agencies’ $5T of mortgages onto the government balance sheet clear. Hank must be hoping the markets bought his `we’ll fix it’ speech because if he actually has to do something, is room for manoeuvre is limited.

Posted in: Federal Agency, Markets, Ratings by David /
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The Economist points out something really cute about the GSE’s having access to the FED window:

The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.

I just love the way unintended consequences sometimes result from attempts to make things better, don’t you? But fortunately no one could think that Fannie or Freddie would abuse their access to the window, so the Economist is just engaging in idle speculation, isn’t it?

Posted in: Federal Agency, Regulation by David /
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A post on Accrued Interest concerning Fannie and Freddie caught my eye. Two quotes. First:

delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae)…

And second

Under current statues, the GSEs minimum capital required is 0.45% of of their guarantee portfolio

So their current level of losses is roughly twice the capital requirement – a level of capital which was presumably intended to cover unexpected losses at a high degree of confidence. If a more craven example of the supine nature of the US regulatory environment were needed, I don’t know where to find it.

Posted in: Capital and Contingent Instruments, Federal Agency, Regulation by David /
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A question to anyone who knows _a lot_ about public sector accounting. Just how much help exactly can the U.S. provide to Fannie and Freddie before those $5T of mortgages consolidate onto the government balance sheet? And would the US still be AAA with another $5T of liabilities?

Update. Bloomberg has caught up with this one.

There’s nothing sacrosanct about the U.S.’s AAA rating, no matter what dogma and orthodoxy might suggest. Many financial assets that claimed AAA status before the credit crunch turned out to be irredeemably tarnished; there’s a non-negligible risk that Treasuries will prove to be similarly spoiled.

The ten year CDS spread on US treasuries settled in Euros is now more than twenty basis points.

Posted in: Accounting, Federal Agency, Ratings by David /
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Over the White House, that is.

Willem Buiter is most entertaining on the GSE bailout:

The financial assistance offered to US homeowners through the spagetti of federal financial inducements (ranging from the tax deductability of nominal interest payments to the subsidisation of mortgage financing provided by the FHA and the GSEs) is not primarily socialism for the rich. It is socialism for the electorally sensitive, rather like the agricultural welfare state that exists in the US.

So let’s call a spade a bloody shovel: nationalise Freddie Mac and Fannie Mae. They should never have been privatised in the first place. Cost the exercise. Increase taxes or cut other public spending to finance the exercise. But stop pretending. Stop lying about the financial viability of institutions designed to hand out subsidies to favoured constituencies. These GSEs were designed to make losses. They are expected to make losses. If they don’t make losses they are not serving their political purpose.

So I call on Secretary Paulson, Chairman Bernanke and Director Lockhart to drop the market-friendly fig-leaf. Be a socialist and proud of it. Come out of the red closet. The Soviet Union may have collapsed, but the cause of socialism is alive and well in the USA. Granted, the US version of socialism is imperfect thus far. The federal authorities have mainly intervened to socialise the losses in the financial sector while allowing the profits to continue to be drained off into selected private pockets. But that is bound to be an oversight. It surely cannot be the intention of such committed Marxists to target taxpayer-funded largesse solely at the very rich and at a few favoured, electorally sensitive constituencies. Fannie and Freddie are, or will be, safe in the hands of comrades Paulson, Bernanke and Lockhart.

Posted in: Federal Agency, Photography by David /
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Calculated Risk has a post on Fannie and Freddie that defies belief. Commenting on the suggestion that the US government should bail out the agencies without screwing the stock holders – for instance by buying new sub debt to provide liquidity – they say:

If this blog’s comment threads are any kind of representation of a slice of reality–I am often agnostic on that question, but still–there are more than a few people who are more interested in getting a front-row ticket to a morality play than working through a financial crisis with the least (further) damage to the banking system. Lord knows that a lot of bad policy can be floated along under the guise of “pragmatism,” but I for one would rather try debating with a pragmatist than a purist or a moralist.

Two words Tanta – moral hazard. It is vital that any government support of the agencies is at the cost of the equity owners. To do anything else isn’t pragmatism, it is the grossest and least defensible public subsidy of the providers of risk capital. By all means let the US government support the Agencies if it judges that to be in the national interest. But do it in such a way that those who were perfectly happy with the rewards of Fannie and Freddie’s absurdly high leverage also bear the consequences of it. Capitalism is a broad church but it does not include privatised gain and socialised loss.

Posted in: Federal Agency, Moral Hazard, Photography by David /
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Taken from CNN and Bloomberg, some tidbits on the GSEs:

• At the end of last year, Fannie alone had packaged and guaranteed about $2.8 trillion worth of mortgages, approximately 23% of all outstanding US mortgage debt.
• Egan Jones estimates that Freddie alone will need to raise $7 billion over the next two quarters due to writedowns and losses. The company’s market capitalization is $8.7 billion.
• In an April report, Standard & Poor’s said an Armageddon scenario whereby Fannie and Freddie are insolvent is unlikely, but that if it happened, the cost to U.S. taxpayers would be more than $1 trillion.
• Former St. Louis Federal Reserve President William Poole said recently: “Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer”
• “I worry about those institutions,” retired Richmond Fed President Alfred Broaddus said. “They are huge. They dwarf the Bear Stearns issue. In the very worst case scenario, I don’t know how you do it other than extend money and the public takes the loss.”
• CDS on Fannie and Freddie senior debt now trade at more than 80bps.
• The one year return on both of the stocks is approximately -80%.

Update. The FT fills in some more background.

Investors were unnerved by a warning from Bill Poole, former president of the Federal Reserve Bank of St Louis, that the chances that a bail-out of Fannie and Freddie might be needed were increasing.

Mr Poole said Freddie Mac owed $5.2bn (£2.6bn) more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules.

And needless to say, investors have taken note despite attempts by Bernanke and Paulson to reassure the markets. Fannie was down 13% yesterday; Freddie, 22%. It seems that my earlier sarcasm really was justified. Oh and the NYT says that a regulatory takeover is being considered. It’s probably too late to short the stock, but is selling default swaps on the senior debt a good trade at the moment?

Update. John Dizard thinks so. From the FT:

I have what Wall Street calls a “strong buy” recommendation: buy the senior debt of Fannie Mae and Freddie Mac. You can get a risk-free spread over US Treasuries. If you want more leverage, and you have a line with a credit default swap dealer, then sell five-year protection on the names.

Posted in: Federal Agency, Writedown by David /
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Specifically they are down about 20% so far today, with Bloomberg reporting that they may need tens of billions more capital. The agency/treasury spread is over 200bps, and CDS on these (supposedly US government credit risk) firm’s sub debt are at around 180 over. The predicted chickens are coming home to roost. And we all know that chickens in the bath are not a lot of fun.

Posted in: Federal Agency, Markets by David /
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…apparently. According to Reuters:

The two top members of the U.S. Senate Banking Committee announced on Monday that they have a deal that will create a multi-billion dollar mortgage rescue fund and a new regulator for Fannie Mae and Freddie Mac.

Posted in: Federal Agency by David /
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Paul Volcker has cottoned on to the bizarre and currently unhelpful nature of the GSEs I discussed a few days ago — the epitome of privatised gains and socialised losses. From WSJEconBlog via Naked Capitalism:

…he questioned the role of government-sponsored enterprises such as Fannie Mae and Freddie Mac during the recent turmoil in mortgage markets. “Where were Fannie Mae and Freddie Mac?” Volcker said.

“What kind of system do we have” when agencies charged with the public interest in housing are instead “out serving the interests of their shareholders?” he added.

What kind of system indeed. As always, the rules determine the behaviours observed.

Posted in: Federal Agency by David /
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Bloomberg reports a miserable quarter for Fannie Mae:

Fannie Mae, the largest U.S. mortgage- finance company, reported a wider loss than analysts estimated, cut its dividend and said it will raise $6 billion in capital

The $2.19B, while eye catching, isn’t the real story. For that let us turn to the New York Times:

As home prices continue their free fall and banks shy away from lending, Washington officials have increasingly relied on two giant mortgage companies — Fannie Mae and Freddie Mac — to keep the housing market afloat.

But with mortgage defaults and foreclosures rising, Bush administration officials, regulators and lawmakers are nervously asking whether these two companies, would-be saviors of the housing market, will soon need saving themselves.

Remember Fannie and Freddie are not regulated as banks. They would be capitally inadequate if they were as their leverage is frightening: a combined $83B of capital vs. $5T of debt according to the NYT. Instead they have the Office of Federal Housing Enterprise Oversight, which has consistently acted as their cheerleader. With losses rising politicians are beginning to worry:

“They are on real thin ice financially,” said Senator Richard C. Shelby of Alabama, the senior Republican on the Banking Committee. “And the way the law is written right now, there is very little we can do to correct that.”

The real issue is how these entities came to be in the first place. Their debt is viewed as government guaranteed (although that is not explicit). Yet they have shareholders. In addition to not bearing the weight of Basel, they have preferential tax status and are exempt from many SEC securities regulations. But they are hardly government pawns:

“We have to bow and scrape and haggle each time we need help,” said a senior Republican Senate assistant who spoke only on the condition of anonymity [...]

In a March meeting, Freddie Mac’s chairman, Richard F. Syron, bolstered those fears by saying the company would put shareholders’ interests first.

This is clearly bizarre. Either regulate them as banks and let the shareholders keep their stakes or nationalise them and have them act in the interest of the state. Privatised gains and socialised losses is not a good compromise.

Update. Talk about putting out the fire with gasoline. The Office of Federal Housing Enterprise Oversight has just said that it will lower requirements for surplus capital at the agencies to 15% from 20%, allowing the agencies to increase their leverage yet further. This might help the mortgage market in the short term but the US tax payer will be left holding the baby. S&P already thinks this is a trillion dollar problem. In the immortal words of Homer Simpson, shimatta-baka-ni.

Further Update. The FT reports that Fannie is planning a $5.5B capital raising. Too little, too late.

Posted in: Federal Agency, Photography, Regulation by David /
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…to Japan some years ago and now might just possibly be on the cards for the U.S.? Losing their triple A. The WSJ reports:

The performance of government-sponsored enterprises like Fannie Mae and Freddie Mac could have a direct impact on the national economy and, more importantly, U.S. credit standing.

So-called GSEs enjoy implicit government guarantees and could cause the U.S. to lose its sterling triple-A rating if the government were forced to come to their rescue, Standard & Poor’s said in a report Monday.

Add the FHLBs into that mix, and you do have a combustible mixture.

Update. FT alphaville has the picture opposite to show the importance of the GSEs portfolios to the banking system.

Just look at how that river of mauve is widening across the page. Meanwhile the WSJ estimates the cost of bailing out Fannie and Freddie at 10% of GDP.

Posted in: Federal Agency, Ratings by David /
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Following yesterday’s announcement that a Carlyle fund is in default over its repo arrangements on Agency RMBS, Bloomberg comments on the agency/treasury spread:

Yields on agency mortgage-backed securities rose to their highest relative to U.S. Treasuries in 22 years as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.

The difference in yields, or spread, on the Bloomberg index for Fannie Mae’s current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 7 basis points, to 223 basis points, the highest since 1986 and 89 basis points higher than Jan. 15.

Why? There are a number of reasonable explanations. Firstly and most obviously there are more buyers than sellers of treasuries and more sellers than buyers of agency MBS. Why does no one step in to arbitrage the spread? Because there is little risk capital in this market that is not deployed, and/or anyone with money is waiting for things to get worse.

Next, even if we do accept that an arbitrage relationship holds between treasuries and agencies, (1) the liquidity premium on agencies is high; (2) the credit spread on agencies is increasing [since as the agencies lose money and become more highly leveraged, the likelihood of government support must decline somewhat]; and (3) regulatory risk in the mortgage market makes it unclear what the cashflows of the underlying assets will be anyway. (Remember even if the agency guarantee holds good, a reduction of principal on the asset pool causes prepayment, thus regulatory risk effects the optionality of the pass through.)

Posted in: ABS, Bonds and CBs, Federal Agency, Mortgages by David /
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Goodness, let’s take one entity which has just recorded a whole year loss of $2.1B, add in another to get to a total of $11.3B of accounting errors, and then let them take more risk in a rapidly falling market backstopped by the tax payer. Winning idea. What could possibly go wrong?

Posted in: Federal Agency, Markets, Mortgages, Regulation by David /
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The crunch is getting crisper if not more chocolatey. Currently suffering are:

• The monolines. CIFG for instance is about to get a capital injection according to the WSJ. Now would be a great time to set up a new monoline, writing pure muni business. Perhaps Warren will help?
• Any bank relying on the securitisation market for part of its funding, according to FT alphaville.
• The ratings agencies, who many people (including David Einborn) think screwed up big time.
• Fannie and Freddie, who need more capital, according to CNN.
• Anyone who was long equity: the markets have been falling, wiping out the gains so far this year on the S&P according to Bloomberg.
• RMBS, CMBS, CDO and even covered bond holders.
• As we said yesterday, the writers of liquidity lines and anyone who wants to issue ABCP:
  
  (This figure and the next one come from an article by Charles Calomiris.)
• And just to end on a cheery note, Hank Paulson says 2008 will be worse than 2007 for the U.S. housing market according to the Guardian. Not that 2007 was so wonderful:
  

I’m personally not in the the-world-is-coming-to-an-end school but these signals are undoubtedly strongly negative. Let’s be careful out there.

Posted in: Federal Agency, Markets, Monoline, Mortgages, Ratings by David /
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