Tuesday, October 28, 2008

Nothing has changed with Agency debt

On Thursday, James Lockhart,head of the Federal Housing Finance Agency (formerly OFHEO), said that the U.S. government is providing a "explicit guarantee to existing and future debt holders." He later retracted the statement. Today, Anthony Ryan, Paulson's right hand man at Treasury, said that Fannie and Freddie are "effectively guaranteed" by the U.S. government.

I get what both are trying to do. Spreads on GSE debt had historically traded 20-30bps over Treasuries. Even just before the Treasury forced the two mortgage giants into conservatorship, Agency spreads were around 80bps over Treasuries. Now 5-year non-call notes are trading at spreads of 155bps.

At those spreads, Fannie and Freddie have effectively stopped issuing term debt, and have instead been funding entirely through discount notes (the GSE equivilant of commercial paper). I admit that the discount notes have been gobbled up by "government" money market funds, and thus there is currently no concerns about funding at the right now. But remember that the government took the GSEs into conservatorship in part to ensure continued debt funding. I'm certain they didn't expect Fannie and Freddie's cost of funding to increase after the take over.

And as long as the GSE's debt costs remain high, its going to be more difficult for them to be active in the secondary mortgage market. The Treasury has an explicit goal of forcing mortgage rates lower to both improve affordability and to facilitate a refinancing wave. No doubt Ryan and Lockhart would like buyers of 2-year Treasury notes, currently at 1.54%, to consider 2-year Freddie Mac paper at nearly double the yield.

The U.S. Treasury will have difficulty extending a literal backing to the GSEs, as it would cause them legal problems with the debt ceiling. You can say that by virtue on the conservatorship, which includes a $100 billion credit line, the government has de facto guaranteed the two agencies. I'd agree with that. You can say that the government has no incentive to hurt Fannie and Freddie bond holders, even if mortgage losses accelerate from here. I'd agree with that too.

You could even say that Agency spreads in the +150 area don't make any sense at all given the de facto guarantee position. I agree with all these things.

The danger is that Asia doesn't seem to agree. Selling of both Agency debt and MBS securities have been concentrated in Asia the last several days. We know that that Taiwanese insurance regulators are limiting allowable exposure to U.S. agency mortgage-backed securities, claiming the credit rating cannot be believed. If China or Japan were to come to the same conclusion, there would be real problems real fast.

The good news is that despite heavy selling from Asia, agency spreads (and MBS spreads for that matter) have moved wider slowly. Agency spreads are about 60bps wider this month, whereas corporate spreads have moved 117bps wider. The reason is that there is a much larger universe of natural buyers for agency debt compared with corporate debt. Agencies are one of the easiest sectors for conservative, income oriented investors to simply buy and hold.

I think this is especially true if you have shorter-term money to invest. Agencies at 3% yields look a hell of a lot better than most alternatives. I think if you can be patient, agencies will turn out to be a solid trade.

1 comment:

capitalhill said...

Maybe the issue with agency spreads isn't a retreat from the agency market--although that seems to be the case in Asia--but ridiculously low yields in Treasuries. And maybe the correction will come eventually with agencies outperforming Treasuries as the market resumes a willingness to take credit risk.