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Today we focus on the bazooka bailout by the U.S. government of Fannie Mae and Freddie Mac and its likely short and long term effects on the economy.

On Sunday, September 7, 2008, the U.S. Treasury finally recognized the inevitable – that Fannie & Freddie (GSEs) are insolvent. Secretary Paulson’s adopted action plan entails 4 dimensions: 1) Expand the GSEs combined investment portfolio from currently $1.55trillion to a max of $1.7trillion by 2009 and then start shrinking it by 10% per year; 2) the Preferred Stock Purchase Agreement includes an immediate $1bn stake in each company, with option to expand the preferred equity stake to max $100bn in each company. The Treasury’s new preferred equity is senior to existing preferred and common stockholders but junior to existing senior and subordinate debt holders. The creditors’ interest and principal payments are guaranteed by 3) a new secured lending facility for GSEs, including the Federal Home Loan Banks, intended to serve as an ultimate liquidity backstop. 4) Treasury is also initiating a temporary program to purchase a yet unspecified amount of GSE MBS starting later this month.

Secretary Paulson underlines the temporary nature of this 4 point program that expires December 2009. Until then, Congress is advised to engineer a long-term solution for the GSEs that removes the current ambiguity resulting from private ownership with public financial backing. See: “Overview of Long-Term Solutions for Government-Sponsored Enterprises (GSEs)”

Did Secretary Paulson live up to his role as prudent steward of the public purse and secure the best deal for taxpayers while containing the systemic risk emanating from the GSEs? Pundits’ reactions are mixed but the markets distinguished quickly between the real winners and losers. Predictably, agency debt holders experience large capital gains as spreads recede towards the long-term 100bp average – by itself a yearly subsidy to the tune of $50bn courtesy of the U.S. taxpayer). But the biggest winners turn out to be subordinated debt holders - once again in virtue of large numbers CDS contracts outstanding that are now being unwound at near par. Existing preferred and common shareholders take a beating and won’t receive any dividends but they are not wiped out as would be expected in insolvency. Still, a few regional banks are likely to suffer from large GSE preferred stock holdings.

Judging from the record spike in the price to protect U.S. public debt against insolvency, taxpayers are likely to feel the pinch down the line, even in the absence of large upfront outlays. Given the largely prime quality of assets and assuming an ultimate loss rate of 5% on the GSEs total debt of $5.3trillion that is either owned ($1.6trillion) or guaranteed ($3.5trillion), Nouriel Roubini quantified the expected losses from a bail-out to amount to $250bn - $300bn back in June – as a reminder, the total taxpayer bill for S&L was $140bn then and $300bn in today’s dollars. Importantly, GSEs hold $320bn of private-label securities on their balance sheets, or 20% of their combined assets. Of these, approximately $217bn are backed by subprime and Alt-A mortgages. It is a legitimate question to ask whether Treasury could end up holding this ‘toxic waste’ in its efforts to put the GSEs on a sound footing by 2010?

How will the seizure of the GSEs affect the housing and wider credit markets going forward? Some analysts are confident that whatever alleviates the stress in the housing market at the heart of the current turmoil, will by consequence have a positive impact on the wider credit markets. Other observers are less sanguine – after all, the GSEs have nothing to do with banks’ large amounts of off-balance sheet assets that continue to drive write-downs and interbank spreads. Neither can the GSEs prevent U.S. home prices from falling further upon a large and growing oversupply in the wake of record foreclosures and further employment disruptions to come down the line. See: “Can the GSE Rescue Solve the Interbank Liquidity Hoarding at the Core of the Credit Crisis?”

The GSE bailout stoked risk appetite initially but, like past attempts to solve the credit and housing crisis, the confidence boost faded on the recognition that the bailout was no magic bullet to a weak U.S. and global economy. U.S. stock indices rallied more than 2%, led by Financials, on Monday but turned back down on Tuesday after commodity prices fell and Lehman failed to woo its Korean suitors. Treasury yields rose on the reversal to the flight-to-safety bid but long-dated Treasuries retraced their losses by the end of Monday on mortgage convexity hedging, which continued into Tuesday. The U.S. dollar appreciated to a 2008 high of $1.41 per euro on equities buying then turned around Tuesday as Lehman's precipitous share drop re-ignited concerns about the U.S. financial sector.

The medium-term outlook for equities is still bleak. According to some analysts, the GSE bailout may have shortened the time it would take for the U.S. housing market to stabilize but it remains on the scale of years. The fall in mortgage rates should contribute to an improvement on the demand side, although the impact of falling mortgage rates is usually affects home sales with a lag of about a quarter. Stocks with foreign exposure may weaken as the rest of the world slows down. U.S. consumers and firms will still have to grapple with tighter credit and asset deflation. Barring further upsets related to the economy, financial sector or housing market, the GSE bailout is a positive for equities. Optimistic analysts believe the recession's end is as near as year-end and so is the stock market bottom that usually precedes the end of recessions. In more pessimistic scenarios, stocks will continue to languish with a stagnant U.S. and global economy in 2009. The crumbling 'safe haven' in commodities may dim the energy and materials sectors, pulling out the last leg from the U.S. equity market. See “U.S. Stocks: Bear Market to Bottom When Recession Is Recognized?“

The dollar has benefited from flight-to-safety by domestic investors and by a reassessment of the global outlook. The GSE bailout might have whittled away further impetus for the Fed to cut rates, providing support for the dollar. The now explicit backing of agency debt could also restore foreign demand for agencies that has been anemic in the last few months with foreign investors trimming their overall holdings. See “USD Rally: Is the Dollar a Safe Haven from Global Slowdown?” and “Foreign Governments Shying Away from U.S. Agency Debt?”

However, the increase in government debt resulting from the bailout could mar the U.S.'s credit rating. The expected rise in the Treasury supply could depress bond prices should demand fail to rise along with supply. As a result, the GSE bailout would have a lifting effect on Treasury yields but mortgage-related buying and safe haven flows could offset the effect. Reduced expectations for the Fed to cut and the deflationary impact of falling commodity prices could tip the balance towards lower yields. Initially the GSE bailout-related issuance will affect T-bills and intermediates more than longer maturities. At this point, it is unclear how much longer-dated supply will increase. See “Will GSE Bailout Push U.S. 10-Year Treasury Yields Above 4%?” and “U.S. Sovereign Rating: Downgrade Approaching?”

Also in the Monitor:

·         World Economic Forum's New Financial Development Report

·         OPEC: On Hold at September Meeting?

·         Canadian Equities: TSX Hemorraging as Oil Falls

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Christian Menegatti
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