Sunday, September 7, 2008

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


Anonymous said...


The question for the broader markets is, by how much will rmbs spreads decline? Its really rmbs -- and not Agency -- spreads that matter to the housing market and the real economy.

Presumably, rmbs spreads should be zero, right? If F&F guarantee the securities, and if the government explicitly stands behind F&F, then the chances of losing money on rmbs are equal to Treasury risk.

So, do rmbs spreads collapse to zero (ex the premium for prepayment risk) on Monday? If so, its unlikely that Treasury rates will rise by the same amount, so the result is a net positive to the economy, right?

Except that for spreads to collapse, you need buyers with balance sheets. As long as there is some question, any question, as to the status of Agencies vs. Treasuries, they will not be freely interchangeable by Central Banks. If that's the case, F&F guaranteed rmbs spreads should remain "irrationally" high.

In other words, there's an imperative here to give an explicit guarantee, as that is the only thing that will create massive buying of Agencies. However, its not even clear that the GSE bail-out legislation authorizes Treasury to make the guarantee explicit.

John Hempton said...

I have not read the legislation - and am not going to now -

But my understanding is that the authorisation is effectively unlimited UNTIL end 2009. So no they cannot entirely guarantee the long dated Frannie paper.

They can however inject an insane amount of money - which will have the similar effect.

The spread COULD be more than 30bps (ex refi risk) tomorrow - but I would be suprised.

Then again I have been suprised before - so...

The eventual structure leaves me in the dark as much as you. However if the Treasury injects $500 billion in subordinated capital then I suspect the spread goes very low indeed.

The deal - swap 500 billion in Treasuries for 500 billion in higher yielding subordinated Frannie debt. 500 billion in long dated treasuries leaves Frannie solvent.

If you don't think 500 billion is enough try a trillion. That ought to do it.

Covenant the treasuries so they can only be sold to make good net reductions in Frannie obligations if you want.

This is highly speculative - so for the moment I really want to leave it till we see the deal.


dWj said...

A lot of banks in the United States own preferred shares in Frannie; Bernanke, whose primary academic accomplishment was describing the great depression in terms of widescale disintermediation, may well be pressing for the banks to be made whole for much the same reasons he wanted Bear Stearns creditors made whole: if they aren't, there could be very widespread knock-on effects and a lot of deleveraging.

I would imagine Paulson would listen to a heart-felt plea by Bernanke.

SG said...


Making the preferred senior to the government's position for losses is not in question. it's a check-mate situation. Two reasons:

If the banks holding GSE preferred have to write it off it will send many of the smaller ones to the FDIC, which from a public-panic-perspective is a worse problem than overpaying here and holding one's idealogical nose that much more tightly.

The second reason is way bigger (really). If anything more than a "suspension" of preferred dividends occurs (up to 5 years, I think) as spelled out in the prospectus, it will be a CDS-triggering credit event. As I understand it, there are more $ volume CDSs outstanding on fannie & Freddie than any other names. Disorderly settlement of counter-party risk anyone?


ps - regarding collapsing spreads, it seems to me that with the Russians having to support the ruble recently, and declining imports from China & Korea, and prices for oil falling off, there's going to be a marked decrease in FCB flow into US debt anyway. And this story about the Chinese CB makes me wonder how much more risk averse they are feeling these days for their own reasons:

John Hempton said...

Steve said:

The second reason is way bigger (really). If anything more than a "suspension" of preferred dividends occurs (up to 5 years, I think) as spelled out in the prospectus, it will be a CDS-triggering credit event. As I understand it, there are more $ volume CDSs outstanding on fannie & Freddie than any other names. Disorderly settlement of counter-party risk anyone?

Disagree. If there is a CDS triggering event you get to put the insured objecct at par. It it is a preferred those who wrote the CDS wear the losses. Tough.

If it is senior they get to put something that yields 100bps above treasuries at par when it is guaranteed by the treasury. They ain't gonna do that.

No counter party problem.


I suspect they will want to haircut the preferred in some way.

But we find out shortly.


Anonymous said...


One thing that appears certain -- based on the confluence of press reports -- is that Treasury will make quarterly capital injections based on losses incurred.

In other words, $500b up-front is quite a stretch. Much more likely is a $4b injection into each for the next two quarters. After that, it will be up to the next administration. Hardly an iron-clad guarantee.

Again, anything non-massive is unlikely to result in FCB Agency buying. In fact they may elect to unload into speculative demand.

Of course, all is conjecture at this point. My view, though, is that spreads have remained "irrationally high" after passage of the GSE bail-out exactly because no one expects an explicit guarantee out of this Treasury.

John Hempton said...

Are you suggesting then that the Treasury will leave an implicit guarantee in place and allow Frannie to raise several hundred billion at say 2 percentage points of spread?

Maybe - but if so it is madness.

If you are going to have a government guarantee you might as well get the benefit of it.

A government guarantee whilst paying the spread is insane.

So we now find out - is the senior debt guaranteed or not. To leave the matter open would indicate the Bush administration is totally incomepetent.


Anonymous said...


There are all kinds of guarantees. One gets printed on the prospectus for new Agency issues. Another is a promise to inject capital as needed beyond your administration, which may or may not be honored by future administrations. Then there is proposed legislation that the USG will promise to pay any principal or interest owed by F&F, now and in the future. Finally, there's a nebulous statement the government "stands behind" the debt.

Which of these will we get this morning? Which would satisfy you if you were a CB? We'll find out soon.

Unknown said...

John, wake up! I need analysis. The treasury has spoken and only you can interpret.

I am hoping for stability and lower rates in the mortgage market. Positive for housing. No clue on what will happen to preferred and regular shareholders.

As you are a full 1/2 day ahead of where I sit let us know what the markets think in Australia as well as your thoughts.


CrocodileChuck said...


"This must really pain the Republicans" (from your post).

Capitalism in the US is for suckers. Crony capitalism rules. Enron, Cheney's 'Energy Plan' in the first terms crafted by the OilCo's (still 'top secret'); MilitaryIndustrial Complex/defense contractors; the Executive Branch's Praetorian Guard (Blackwater et al), one can go on, on and on...

60% of the goods and services traded by the S&P 500 never see the 'invisible hand' (transfer pricing/tax avoidance). This is why the effective corporate tax rate is between 5-10% of profits. Remember the 'tax amnesty' of a couple of years back?

The US is well on its way to becoming a banana republic-aided, abetted and catalysed by the Republican Party.


John Hempton said...

Crocodile Chuck is more cynical than me - which doesn't mean he is wrong about a large number of Republicans.

But I work on the assumpton that most the rank-and-file of political parties actually believe they are right and moral. For instance many rank-and-file republicans - including a woman who might one day be president - really believe that the world was created in six days about 6000 years ago. They may be wrong. They may reject all evidence - but they sincerely believe it and they are sincerely offended by "the liberal creation myth called evolution".

I don't think Paulson went to Washington to line his own pockets. That idea makes no sense. After all he was dynastically wealthy anyway.

There is an enormous amount of crony-capitalism in this administration - but Paulson is in Washington because he thinks its the right thing to do - and I suspect he was pained.


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