Call today a lone linkfest! I did not write this piece, and rather I have links below to the original writer and the site that linked to it. They key point I got from this discussion was the spread between FNMA paper and US Treasuries; so I added a visual in the middle of the article to explain this very important indicator of the debt markets.
Found on: Precious Metals forum of InvestorVillage.com
Found via: Words of Wall Street
Ok, PLEASE take 5 minutes and read this discussion on how our system works and what the current situation regarding Freddie & Fannie means along with potential options that our government has. I am still digesting this but one of the key components that stuck out in my mind is the reference to Fannie Mae paper and the trading spread over treasuries as an indication of risk. The comment was:
"HERE'S THE TEST the GSE's have to pass. As long as they can continue to issue debt on a timely basis and in the amount that is required to fund their business at a REASONABLE INTEREST RATE SPREAD over treasuries, then things will be okay (no matter what the financial media says). If they can't, then the sh#t will truly hit the fan. Here's an example of what I'm talking about. Let's say that 5 year FNMA paper historically has traded at 50 basis points over 5 year treasuries. If that spread blows out to 150 -200+ basis points because the bond market vigilantes no longer trust the implied government guarantee that historically has supported it, then the game is over. The government will then have to step in."
The Article: Please pay attention. This might be the most important post you read for a while (even though it does not involve energy directly).
The level of understanding about how our capital markets work in this country (including these talking heads on CNBC and in the media) is pathetically inadequate. For those here, I'm going to try and correct that. The basis of my understanding of this subject did not come from a book. It came from working at Salomon Brothers during the 1970's (a firm - now part of Citibank - that dominated the taxable fixed income markets during that period). I started out as a money market and government securities salesman. My next to last job there (before I left to start my own firm) was as their global money market and government securities sales manager. As a result, I think I know what I'm talking about.
Following the concept of KISS (keep it simple, stupid), I'm going to try and walk you thru what exactly is going on right now as it pertains to Freddie Mac and Fannie Mae. I'm going to go slowly and keep it as simple as I can (at the possible cost of exact technical correctness). Hopefully I will be able to tie everything together at the end in a way that makes this complicated financial situation understandable.
(1) What role does the Treasury Department play? - It is the role of the Treasury to make sure that the U.S. government has enough money to fund the obligations of the U.S. government. Whether the government is running a fiscal surplus or deficit, it is their responsibility to determine how much money should be raised and when. It is also their responsibility to determine what the maturities of this debt should be. The amount of each offering is set by the amount of debt maturing (thus requiring refinancing) as well as any additional debt that may be needed above and beyond that (i.e. to fund that year's deficit). If you check, this is done thru weekly Treasury Bill auctions, quarterly refundings and other periodic treasury auctions such as the monthly two year note. These auctions are not conducted by Treasury. They are conducted by the Federal Reserve Bank of New York thru their network of recognized government securities dealers. The important thing to note here - these Treasury financings have absolutely no impact on the money supply. They simply determine how much Treasury debt is outstanding (i.e. the national debt).
(2) What role does the Federal Reserve play? Besides facilitating the Treasury's effort to fund the operations of the government, the FED is charged (along with many other things) with determining how much money is in the system. So how does the FED expand or contract the money stock? SIT DOWN AND PAY ATTENTION. All they have to do to create more money is to buy a Treasury bill, note, or bond from one of the recognized government securities dealers (i.e. $1MM treasury security goes to FED, $1MM is released into the system as payment). IT IS JUST THAT SIMPLE. It is from this money stock creation/contraction (that can be raised or lowered at will by the FED simply by buying or selling treasury or GSE agency securities), that then gets circulated throughout the financial system, that is the starting block for determining such things as M1, M2, and M3. POINT TO REMEMBER - only the FED can monetize debt and THIS IS HOW THEY DO IT.
(3) With (2) above in mind, The FED right now has a portfolio of around $800B (my numbers are probably off, but the magnitude isn't). That means that they have created $800B of "money" (which gets multiplied many times over as it winds its way thru the banking system thru the mechanism of bank deposits and bank loans (less reserve requirements)). Up until the Bear Stearns bailout, all of this $800B of "money" was backed by a portfolio of U.S. Treasury and Agency securities. With all of these "clever" new financing vehicles that were created by the FED to bailout Bear Stearns and to keep the IB's and money center banks afloat, roughly half of this $800B AAA+ portfolio has been loaned out thru the Discount Window in exchange for toxic waste garbage (sub prime MBS, etc.). [It should be noted here that the FED does not own this garbage. It is simply financing it for the street since no one else will. The hope is that they will be able to get their original securities back (and get the garbage off their books) when the credit markets normalize.]
(4) What role does FNM and FRE play? - These two GSE's [government sponsored entities] are the only reason that we have a functioning 30 year fixed rate mortgage market. Reason? As government sponsored enterprises, they have long enjoyed a competitive advantage in terms of how they can fund themselves. They have historically paid only a slight premium over the level of treasury (i.e. risk free) interest rates (for any given maturity) for their money. As a result, they have been in a much better position than any private sector mortgage provider to be able to "lend long" and "borrow short". It should also be noted that FRE/FNM are the bedrock of the secondary mortgage market in the country (since they own roughly half the residential mortgages in the country and process many others in one way or another). I haven't looked in a long time, but it is my guess that the average duration of FRE and FNM's 5T of debt is under 3 years (REMEMBER THIS POINT).
So let me cut to the chase and try to tie all of the above together as it pertains to the current crisis that FNM and FRE and the FED and the Treasury now face and what options the government really has at its disposal to attempt to solve this problem..
So as we sit back this weekend and try to figure out what the government's options are in regards to Fannie Mae and Freddie Mac, let's look at some of the options being proposed by some of these financial, talking head bozos on CNBC and elsewhere:
(1) Open the Discount Window - This ranks as the dumbest idea ever. Why? Simple. The FED's balance sheet is only $800B. Half of that has already been exchanged for toxic waste to keep Wall Street afloat. They are probably going to need the other half when Lehman Brothers or someone else starts to seriously sink (which will most certainly happen). In addition, how is opening the discount window going to solve the GSE's problem of rolling over their $5+ TRILLION in debt when it matures? Keep in mind that this massive debt also has a very short duration. The ONLY way the FED could do this would be to MONETIZE whatever the $ amount the GSE's came to the discount window for by going into the market and buying massive amounts of treasury securities. We're talking potentially TRILLIONS here since this action (i.e. the GSE's going to the discount window) would in all probability shut them out from issuing any additional debt into the debt markets at anything close to a reasonable spread to treasuries.
LESSON LEARNED - No way is the FED going to open the discount window to the GSE's.
(2) Nothing changes - business as usual. According to Paulson, the government has no current plans to "takeover" the GSE's. They're just going to monitor the situation closely. This might work. It might not. HERE'S THE TEST the GSE's have to pass. As long as they can continue to issue debt on a timely basis and in the amount that is required to fund their business at a REASONABLE INTEREST RATE SPREAD over treasuries, then things will be okay (no matter what the financial media says). If they can't, then the sh#t will truly hit the fan. Here's an example of what I'm talking about. Let's say that 5 year FNMA paper historically has traded at 50 basis points over 5 year treasuries. If that spread blows out to 150 -200+ basis points because the bond market vigilantes no longer trust the implied government guarantee that historically has supported it, then the game is over. The government will then have to step in.
MY ADD-ON ---> To visualize this, I went to the Vanguard Bond Yields page and superimposed a chart of US Treasury's onto a chart of US Government Agency yields, to see what the spread is between 5 YR FNMA paper and 5 YR Treasury yields; as you can see, it is about 101 basis points (4.30% - 3.29% = 1.01% spread or 101 basis points):
(3) The government steps in - The options here are numerous.
(A) The government puts an explicit government guarantee on all of the GSE's outstanding debt. The benefit to this is that it will insure that the GSE's can continue to fund themselves in the debt market (which is ABSOLUTELY crucial). The downside is that it will officially add this debt to our national debt. [The national debt is currently nearly 10 trillion$. Adding the GSE debt instantly increases the national debt by 50%.]
(B) Congress authorizes the Treasury to raise $100B (for example) in additional debt and to invest those funds into the GSE's (in some form or fashion, you're guess is as good as mine). The good news is that this will preclude all of the GSE's debt from landing on the national debt. The bad news is how big are the real losses that the GSE's will face going forward? Will this $ amount (whatever it is) be enough? Will they still be able to fund themselves at a reasonable spread over treasuries?
(C) Some sort of convoluted public/private bailout scheme that might be attempted by the government in order to save face. This could come in many forms, and I'm not smart enough to figure out which ones (if any) might make sense.
The bottom line to all of this is that whatever happens in regards to FRE/FNM, it won't be a quick easy fix. The problems the government now faces in this regard makes the Bear Stearns bailout look like a walk in the park.
In conclusion, I saw something like this coming. That is why I'm so heavily overweight in gold stocks (38% of my portfolio). Having said that, I never dreamed that the GSE's fall from grace would either be as swift or as stunningly complete as it has turned out to be. We could very easily be looking at a "Black Monday" market situation if the government doesn't get its act together quickly.
JMO. I hope this helps others here understand exactly what is going on in terms of the GSE's.
Northbeach2000
A: Treasury Secretary Paulson's statement issued minutes ago. In addition, the NY Fed has officially confirmed access to the discount window for Freddie & Fannie. Equity futures for tomorrow's open rally with DOW up 89, S&P up 12.60 as of 6:24PM.
Full text via Bloomberg:
Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction.
GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure. In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.
First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.
Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.
Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer. Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards.
I look forward to working closely with the Congressional leaders to enact this legislation as soon as possible, as one complete package.
Freddie has a planned $3Bln auction set for tomorrow, and if that went badly it would have seriously disrupted the credit markets causing who knows how much pain. Clearly, something had to be done.
The actions here are directly focused on restoring investor confidence, and I think both the debt markets and the equity markets will react favorably tomorrow. If it does, stock markets will rally back as financials get a bid, and the spread between FNMA and US treasury (101 bps) that I just discussed earlier today would tighten. Let's see how the markets react tomorrow.
The news about access to the discount window was the rumor that led to a brief rally on Friday; which fizzled out as the fed declined to comment on the rumor. According to the WSJ.com:
The Fed's Board of Governors met Sunday in Washington and voted to grant the New York Fed authority to lend to Fannie Mae and Freddie Mac "should such lending prove necessary," the central bank said in a statement. The move would effectively give the two companies access to the Fed's discount window if necessary, providing a backstop in case the firms were to face a short-term funding crisis down the road.
The Sunday move was in part designed to head off fears about Monday's auction of Freddie Mac notes, which while small, had assumed an outsized importance as a test of investor confidence. Freddie should be able to find buyers for its three- and six-month notes, market analysts said, but there is a chance that some financial institutions and investors may demand to be paid higher-then-usual yields on the notes.
The moral hazard argument will be revived again around the blogosphere. The real question has to be, is this just another temporary fix that is only delaying the inevitable collapse of these enterprises? Time will tell.
I have always stated that 'its all about the buyers, and buyer confidence' when it comes to a local real estate market. Today is no different. Some will argue that interest rates are what drives a real estate market. Others will argue that it is inventory, or lack thereof, that powers the housing market. Or is it jobs? The stock market? The lending environment? Fact is, all of these things play a role in the overall trend of any local housing marketplace, but in the end, its all about buyer confidence. To put it simply, if there are no buyers, how will product move without a significant reduction in the price? The question of WHY buyer's lost their confidence, brings us to answers like higher rates, tighter lending, will the asset depreciate, job insecurity, negative wealth effect, etc..
