By now, it’s yesterday’s news that the U.S. Treasury, in conjunction with the Federal Housing Finance Agency (FHFA), have temporarily taken over Fannie Mae and Freddie Mac, placing both government-sponsored enterprises (GSEs) in conservatorship.
Through its move, the government hopes to restore confidence in the GSEs, reduce systemic risk, and improve Fannie’s and Freddie’s ability to fulfill their housing mission. The Treasury and GSEs have initiated preferred stock agreements, with Treasury ensuring that each GSE maintain a positive net worth by periodically purchasing preferred shares when necessary. In return, Treasury will receive $1 billion of senior preferred shares and warrants on 79.9 percent of each GSE’s common shares, meaning taxpayers essentially own 80 percent of the companies. No initial cash infusion was needed.
Increased GSE Buying Power
Common equity shareholders won’t be wiped out, but their investments will be drastically diluted and will be first in line to take on any losses. Dividends have been suspended for both common and preferred shareholders. With no dividend, preferred shareholders essentially will own a perpetual zero-coupon security, making preferred shareholders the biggest losers in the deal, as most market participants had expected that common shareholders would not be taken care of but speculated that preferred shareholders would be rescued.
The agreement provides additional security for senior, subordinate, and MBS debt holders. Interest on both senior and subordinated debt will continue to be paid, which makes subordinated debt holders perhaps the biggest winners. More importantly, both Freddie and Fannie will be allowed to grow their mortgage guarantee business without capital constraint, amounting to $20 billion in mortgage buying every month. Also, the Treasury will purchase new mortgage-backed securities, which are estimated to potentially provide an additional $10 billion per month. So, the $30 billion of monthly agency MBS purchasing should lead to further spread tightening.
The two GSEs will be allowed to increase their portfolios until December 2009, to a maximum level of $850 billion each (both are just above $700 billion currently). After that, they will be required to reduce their portfolios by 10 percent/year until they reach $250 billion.
Effect on Housing Market
One major goal of the government’s plan is to lower mortgage rates for borrowers and make more financing available. Fannie and Freddie had tightened underwriting standards and raised their guarantee fees to build capital. With the government takeover, many are speculating that those fees will be reduced and the standards may be loosened. Combined with the secondary market spread tightening, this should make mortgages more available and cheaper.
The question then becomes, how much credit risk is the government willing to take on? If housing prices continue to fall, looser lending standards could expose the government/ taxpayers to additional losses down the road. With this market continuing to be very emotional and volatile, traders are doing a bit of price discovery to figure out where they want to offer their bonds.
The Bottom Line
One thing we must keep in mind is that while the government backing of senior and subordinate debt, as well as MBS, is now stronger, it isn’t the same as the explicit guarantee that Treasury debt carries. Essentially, the implicit guarantee that was always assumed is now more certain. The spreads on agency debt will not tighten to zero, just as government-guaranteed debt from Ginnie Mae, the SBA and others does not trade equal with Treasuries.
While this plan is a step in the right direction, it does not fix all the world’s problems. It does not make a bad loan good. It does not put an end to rising unemployment and slowing economies across the globe. Financial institutions still have losses to deal with, and credit will continue to tighten as those losses are written down.
For more information on investment strategies for your credit union’s portfolio, please contact ALM First Financial Advisors, (800) 752-4628, or visit www.almfirst.com.
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