Fannie/Freddie Rescue Talks Intensify

Posted by urbandigs

Thu Aug 7th, 2008 11:43 AM

A: Something that will affect all of us, when it happens. I use the word 'when', because quite simply, the only way these institutions are saved is if the US housing market has bottomed already and is in the process of recovery right now. I don't think anyone believes this is the case. Add in the fact that these two have taken very conservative mark downs on their toxic assets so far, when the tradable markets value these 'hard-to-trade' securities at much lower levels, and I get the feeling that the problems are being delayed, and not resolved. On quick view, I see that FNMA 5-YR spreads to treasuries has now widened to about 93 basis points, as investors appetite for Fannie credit risk diminishes. Should this spread widen to 125-150 basis points, we may have a problem on our hands.

First lets get to the charts. Below is a chart comparing 5-YR FNMA Agency yields to 5-YR Treasury yields; showing you the 93 basis points spread, about 10 basis points wider than yesterday:

fnm-fre-yields-treasury.jpg
*table courtesy of Vanguard Bond Yields

Second, here is a chart showing us the rise in premium (+21.9 basis points, or 10.55% since yesterday) required for credit protection (CDS) on Fannie Mae:

fannie-mae.jpg
*chart courtesy of CMAVision Top 5 Widening Spread Movers

I do not have a bloomberg terminal, nor am I a credit default swap trader, so my access to this kind of information is very limited. However, I'll explain to you what I do know as I understand it and you can feel free to correct me or add to the discussion if you are more knowledgeable of these markets.

The CDS trade is the cost of buying protection in case of default. It is compared to zero. if the entity is riskless then the spread should be zero. If you are talking about the change then it's compared to itself on the previous day, same as a stock price change, only here a positive change is bad.

This means that to buy protection on Fannie's subordinated debt you have to pay 230bps per year (times the notional). So for a dollar of notional it will cost you 2.3 cents to insure, hence higher is implying greater probability of default and/or greater loss given default (lower recovery).

The conclusion from this graph is that you can tell there is not much appetite for Fannie credit risk and it's about as bad as it has been in the past.

Both Mish & Calculated Risk have discussion's on Freddie Mac's awful report issued yesterday:

From MISH:

Anyone following Alt-A mortgages knows that Freddie's claim is simply preposterous. Freddie has $130 billion in subprime and Alt-A loans. Somehow CEO Richard Syron wants us to believe the problem will go away if left on its own.


From CALCULATED RISK:
This graph from the Freddie investor's slides shows the default rates of Alt-As vs. the rest of the portfolio.

As we've been discussing, the 2nd wave of defaults it just starting, and Alt-A will be ground zero this time.
For those not in tune with the credit crisis, Alt-A is 'near prime' or those mortgages considered in quality to be in between subprime & prime. News reports of warnings inside Freddie Mac being ignored surfaced this week, and speaks volumes about this entire credit/housing downturn experienced thus far. In short, they wanted to keep the party going! Well, as in all long-lasting parties, the hangover will be great. From NYTimes.com:
The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others.

That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health. In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that "would likely pose an enormous financial and reputational risk to the company and the country."

But as they sat in a conference room, Mr. Syron refused to consider possibilities for reducing Freddie Mac’s risks, said Mr. Andrukonis, who left in 2005 to become a teacher.

"He said we couldn’t afford to say no to anyone," Mr. Andrukonis said. Over the next three years, Freddie Mac continued buying riskier loans.
Just unbelievable. Now, Bill Gross of PIMCO (who owns a ton of US Agency debt) is saying that the US Treasury will be forced to buy as much as $30,000,000,000 of Fannie/Freddie preferred shares to bolster investors confidence for the institutions. Why you ask? Simple. These two institutions borrow short & lend long. With their stock prices in the dump, they wont be able to raise capital so easily by selling shares. If they can no longer borrow short at reasonable rates, we have a very big problem. That is why I included a chart showing you the spread of FNMA 5-YR yields to 5-YR Treasury yields. In normal times, the spread is about 50 basis points. In distressed times, it rises as risk rises. Today, its around 93 basis points. If that rises above 125-150 bps or so, the credit markets as a whole will get very shaky and that is something we just do NOT want right now! Fannie & Freddie must be able to fund themselves and that means investors need to be willing to do so at somewhat reasonable levels!

We truly are at a crossroads and the existence of these two overly leveraged, overly exposed institutions are at grave risk. I wonder what the world would be like if Fannie & Freddie were nationalized, and shareholders wiped out? Thoughts?

Add a comment

12 comments

CAPTCHA Image