Monday, August 18, 2008

GSEs: Fear leads to suffering

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity. Even senior paper is 7-8bps wider on the day. MBS look to be only about 4bps wider.

I've heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he's been up to his eyeballs in 100 bond lots today. Haven't heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.

The catalyst was Barron's (followed by Barclays and Merrill Lynch) saying that a Treasury-backed infusion was only a matter of time, and that common shareholders would be wiped out. Barron's also suggested that preferred shareholders would lose their dividends. I doubt that very much, but more on that later.

The ultimate problem here is best described by Merrill Lynch's Ken Bruce. You can dive into Freddie Mac or Fannie Mae's balance sheet and make a good case that they don't need new capital, at least under current forecasts for housing. You'd therefore conclude that if they were a truly private company, they'd best serve shareholders by trying to stick it out. But they aren't a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs. The case will be made that the collective needs lower mortgage rates, and only a strong, liquid and publicly minded GSE can help bring that about.

And indeed, tax payers take the least risk the sooner action is taken. The more unsettled markets become, the harder it will be the stabilize. And the more unsettled things become, the more losses will be alread baked into the GSEs book. If the tax payer's position in FRE/FNM's capital structure is ahead of preferred shareholders and behind senior debt holders, the risk of the government actually losing money should be low. Where sub-note holders fall remains to be seen.

As for wiping out preferred shareholders... Remember that the big preferred shareholders are smaller banks. I don't think it would make sense for the Administration to bolster one part of the banking system (Fannie and Freddie) at the expense of another part of the banking system (regional banks). And besides, I don't think its necessary to protect tax-payers interests. With Treasury backing, the GSEs will have a luxury they don't currently have: time. Within 3-years or so, I'd expect FNM and FRE to both be profitable on a cash-flow basis. At that time the government can spin it off for a profit or fold it all into FHA.

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don't know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury's next move is.


viking said...

Ken Bruce says the GSEs don't need capital?!

AI, how can you quote this guy?

Once again, you underestimate the crisis...

It's like a broken record over here

PNL4LYFE said...

Regarding the preferreds, is there a way to see the regional bank ownership? Just checking a few random ones on bberg's HDS, it looks like mostly insurance companies. Is this because banks don't have to make filings similar to 13-F?

Regarding the post's title, anyone who has been long this stuff would probably argue that you shouldn't have omitted anger and hate...

maynardgkeynes said...

I am not aware of the federal government EVER seizing a private company (other than an FDIC or FSLIC bank) in peacetime and I doubt that any American administration, Republican or Democrat, will do so. This isn't Cuba or Venezuela. As far as I can recall, the Chrysler bailout did not wipe out shareholders. In the case of the FDIC, the banks are private, but there insurance agreement explicitly provides this right of seizure by contract. Under the US Constitution, the government may seize private property for public use one way and one way only -- through the eminent domain process specified in the Articles of the Constitution. This process has not been started here and there is no reason to think it is about to. At some price, the private equity holders of Fannie an Freddie will be compensated -- I imagine it will be something no less generous than the price accorded to Bear shareholders, and perhaps more generous. These companies have NOT failed nor are they insolvent under US law. Unless that scenario changes, I doubt that will be seized

Accrued Interest said...

Viking: You are the king of not actually reading my posts, but commenting anyway. The whole point is that it doesn't matter if you are the most optimistic guy in the world, FRE and FNM have to be taken out.

PNL: I don't think banks need to file. I'm making that claim based on word on the street.

Dr. Keynes: I think the legal justification will be that they have breeched their minimum capital requirements. They'll then be given a deadline to raise more equity capital or else. And then the "or else" will be the Treasury infusion.

Note I wouldn't expect a literal nationalization. Merely that Treasury invests in a way that makes tax payers senior to all other equity holders. And the result of this will be to render the GSE equity worthless.

Put another way, they won't zero out equity holders by fiat, merely subordinate them to the point that the investment is worth very little.

Not said...

AI: And besides, I don't think its necessary to protect tax-payers interests.

Spoken like an investment banker...

You want to claim credit if your investments increase in value after the governments manipulation -- and get paid for what you did not do.

But when things go sour, you want to share the pain with the tax payer

Bail out your own book

Not said...

Dr Keynes:

The government has defacto seized many companies. Two recent examples: Anderson Consulting, Enron (albeit too late).

Going back in history, the Tennesee Valley Authority is made up of seized (formerly private) utility companies.

None other than the US Supreme Court ruled that municipalities *MAY* seize private property for profit. See the case from two years ago involving New London, Connecticut.

One could also argue that tobacco companies were defacto seized by the Clinton administration. The overwhelming bulk of gross profits and cashflow now goes to the government. If the government wanted to protect the public health, they would have banned tobacco outright (which would clearly protect the public health better than allowing smoking to continue) -- but there is no money for the govt in that.

You might also want to ask many Japanese families on the west coast about whether Dear Old Uncle Sam ever seizes property. Your government took everything and put those families into concentration camps. Lets not bring up the US government stealing land from indians / native americans.

More examples? OK. The government seized all privately held gold during the Great Depression, and retroactively nullified gold based contracts.

Still not convinced? Try driving a car in New York City if the cops *think* you had a drink. Your privately owned car gets seized, period. You are presumed guilty and (Constitution not withstanding), the burden of proof is on YOU to prove the cops have it wrong.

I know what the Constitution supposedly says and protects, but in reality, it doesnt work that way.

And one more thing: both FNMA and Freddie used to be fully owned by the government. They were semi-privatized by the Kennedy administration (and sort of LBJ) in order to create the illusion of a balanced budget... around the same time, NY state created the NY Turnpike Authority. Both examples of the government using off balance sheet financing vehicles LONG before Ken Lay ever thought of it.

Accrued Interest said...

People... read the post... understand the post... then comment. You can even read it twice if you want to. There is no harm in that.

"Not" apparantly you didn't read the previous paragraph. "If the tax payer's position in FRE/FNM's capital structure is ahead of preferred shareholders and behind senior debt holders, the risk of the government actually losing money should be low."

By the way, I'm not an investment banker.

Not said...

AI: I did read your post, and I've been reading your blog for a long time.

All your detailed "analysis" of the GSEs is missing the forest from the trees.

The GSEs are as bankrupt as they could be. No "private" company would have been able to lever anywhere near close to what the GSEs did. LTCM and Bear Stearns had/have very conservative leverage by comparison.

They are political institutions which sell deliberately underpriced "insurance" to over stimulate the housing market.

These are not economically viable entities, no matter what balance sheet minutea you want to blog about