The Reality Based Community and Frannie

Warning: this post is speculative - we have no idea of the structure of the bailout - and I could completely misunderstand what is happeing.

Brad de Long can’t understand why a Frannie bailout needs to happen now.

Funnily enough nor can I except that it does. I didn’t think Paulson would act this fast – and I don’t know what he will do with the preferreds – but thinking about it the action is sensible. [I was considering buying preferreds – so I have little ability here to claim prescience…]

Let’s lay out the argument

• When Paulson got his permission to bail out Fannie and Freddie and made all the reassuring noises he made I thought that Fannie and Freddie debt spreads would drop to 30bps. They didn’t and I thought that was weird. Really weird. I blogged about it here.
  
  
• We should take the world as it is – not as we think it should be and observe that the debts are rolling over at spreads more like 130bps. This is reality and I for one am a proud member of the “reality based community”.
  
  
• There is almost 2 trillion Frannie debt rolling over at a high rate (several hundred billion a quarter). The government effectively guarantees that debt but a perverse market was forcing issue of that debt at 130bps more than Treasuries.
  
  
• If the spread on the debt remained at 130bps then Frannie were doomed. I did the maths in Fannie Mae series.
  
  
• In particular I estimated the earnings power of Fannie Mae at about 10 billion per annum. Fannie has something near a trillion in debt. If the spread is 100bps higher than it should be with the government guarantee then almost all of that earnings potential will be wasted as excess spreads on the nearly a trillion in debt. If the spread remained at 130bps over treasuries then Fannie had nearly no earnings power. No earnings power meant insolvency was inevitable because losses in the book might be something around 80 billion (see Fannie Mae Part III). As there was no earnings power it was inevitable that the government was going to bail them out sooner or later. I blogged here and here about how widening spreads could spell doom for Frannie. I must confess I did not think the spreads would remain wide (as I thought they were irrational) but they have.
  
  
• The Government might have solved this problem by explicitly guaranteeing the debt and leaving the private ownership in place. But that looks silly to me. I would have thought the implicit guarantee was enough – but 130bps tell me it wasn’t.
  
  
• Given this the government was eventually going to have to pay the Frannie senior debt. Over the next couple of years then Frannie was effectively going to raise over a trillion dollars in US government debt – but at spreads 100bps or more higher than necessary. The cost to the Federal government of delay is thus more than 10-20 billion annually over the life of that debt. If the debt had five year maturities on average then the cost just of delay could edge 100 billion.
  
  
• Moreover delay delayed the date at which the implicit government guarantee finally drove down mortgage rates – and hence increased the disruption in housing market.
  
  

The logical thing for the government to do in that circumstance is not delay. [The alternative is to cross your fingers and hope that the debt spreads on Frannie debt dropped to 30bps on their own accord.]

My understanding of US politics (erroneous it seems) suggested to me that this administration would not want to explicitly socialise the problem. Moreover many decisions of this administration are best described by delay and crossed fingers. So I am staggered by rapid logical action. But so be it and for once I think a Bush administration action is sensible.

But I am more staggered that the market forced the action. I thought that the market would see the implicit guarantee for what it was and trade Frannie senior debt at low spreads. But reality has the ability to get in the way of many things. This is just another example.

Being in government sucks. Sometimes you need to make hard decisions that are ideologically anathema. This must really pain the Republicans. But in this instance reality got in the way of ideology.

There is a second hard decision – which is what to do with the preferred. Any solution that leaves the preferreds as senior to the Government capital would indicate that the Republicans have dumped ideology entirely. I am not sure that they should wipe out the preferreds – but I would have a jaundiced view of any deal which substantially pays the preferreds before the government makes a reasonable profit on the capital that they are putting it risk.

John Hempton