2009 Forecast: Agencies and MBS -- Back door huh?

For the rest of the 2009 Forecast series, click here.

I lump agency debt and MBS together because both are basically wards of the state at this point. They are also the best example of Quantitative Easing working that we have so far.

5-year bullet GSE debt (that is, non-callable) has declined in spread from about +150 in October and November to about +80bps. It will probably get down to about +50 before stalling there. Historically agency debt traded between +20 and +40bps, but I'd say that in a lower liquidity environment, agency paper won't get that tight.

80bps ain't nothin' these days. With the 5-year Treasury now below 1.40%, one could argue that Agencies are generating 57% more income than comparable Treasury bonds. That's going to continue to attract real money buyers looking for something that's both safe and liquid.

MBS suffer from a severe negative convexity problem. MBS investors have essentially sold short an interest rate option to the underlying mortgage borrowers. Those borrowers are now almost universally in the money. Many borrowers will have difficulty actually refinancing (more on that below) but regardless, the price for MBS securities will have difficulty rising above $104 or so with an embedded in-the-money option with a $100 strike.

To see what I mean, notice the price spread across the coupon stack (using Fannie Mae 30-year MBS for February settlement):

• 4.5% Coupon: $101.938
• 5%: $102.750
• 5.5%: $103.203
• 6%: $103.656
• 6.5%: $104.500

This is the current dollar price for a mortgage security with the indicated coupon. Typically the underlying mortgages have a rate 0.5% higher than the coupon rate. Notice, for example, that the 6% bond at $103.656 is less than one point higher than the 5% at $102.75. To me that's telling you that if rates were to fall by 100bps from here (implying the 5-year Treasury is 0.40%), the 5% mortgage would only improve in price by 1 point.

All this is to say that those hoping for price appreciation out of MBS should look elsewhere. But those looking to just collect fat income may have found a home.

Say you buy a generic 6% Fannie Mae MBS at $103.656. According to Bloomberg, that bond will pay at approximately 51 CPR (if you aren't a bond person, just assume that means 51% of the loan will pay down each year, that's close enough). That produces a yield of 3.09% with an average life of 1.5 years.

That isn't half bad considering that Treasury bonds in 1.5 years are yielding about 0.40%. You have some reinvestment risk as the mortgage pays down, but by 1.5 years rates may be rising again, and so maybe that's a good time to be reinvesting anyway.

If you are willing to do a little more work, you can do much better. Say you can find a pool with mostly 2006 borrowers. Most of those borrowers have experienced negative home price appreciation to some degree (not as bad as you might think because we're only talking about conforming loans here, i.e., loans under $417,000). Anyway, couple this with a pool full of borrowers with 90+ LTV? Or mostly coastal geographics? Or relatively low credit scores? You might have a mortgage pool that will repay much slower than average.

Say you can pick a pool that pays at 40 CPR instead of 51 CPR. That increases your yield to 3.82%. 30 CPR? Now its 4.39% wih a 2.8 year average life. That compares very favorably with the 3-year Treasury trading at 1%!

Finding these kinds of pools is somewhat easier in hybrid-ARMs, which I love here on a pure relative value trade. But beware, the liquidity is much weaker in this sector. Otherwise I'd be a bigger overweight in hybrids than I already am. You can also get a lot of good high LTV loans in the GNMA space.

So if you are going to just buy and hold and don't care about keeping up with Treasuries in a rally, MBS are probably as good an investment as any. But I'm underweight MBS, focused entirely on the kinds of specialized pools that I described above. I've basically dumped all my 5.5% and lower bonds.

So to make a prediction about the sector, I'd say the the Fed's continued support will keep dollar prices relatively high, even if Treasury rates back off a bit. But overall I expect MBS spreads will perform extremely poorly should rates fall from here, and that has me cautious on the sector. I'd add heavily to MBS if the 5-year broke 1% or the 10-year broke 1.6%.

Callable agencies are kind of the worst of all worlds. There is no value-adding opportunities through pool selection akin to what can be done with MBS. And you have the same negative convexity problems, where if rates fall you get called away and if rates rise you get crushed. So I'd avoid most callable agency issues.

My God, they aren't kidding!

The Fed will be buying up to $600 billion in debt and MBS backed by Fannie Mae and Freddie Mac. Yeah, that'll move the market. Today we had Agency debt 30-40bps tighter, swaps about 15bps tighter, and MBS about 35bps tighter.

Here is the quick take from that. I love agency and MBS debt for long-term holders, but I'd probably wait for this to settle out before buying anything. This week is classically a poor liquidity week, and we're living in a poor liquidity market. So every event is going to result in outsized moves. You are smarter to buy on the second round, not the first.

Also this should be effective in lowering mortgage rates. Already I'm hearing borrowing rates should be down around 5.5% after today's move. But given where the 10-year Treasury is, mortgage borrowing rates should be able to drop down below 5%. That would help a lot in creating a refi-wave as well as improving housing affordability.

Meanwhile, Goldman priced their FDIC insured deal today at 3-year +220. Immediately traded down to +200. Morgan Stanley, J.P. Morgan, Citigroup, and Bank of America should all be coming with similar deals either this week or next. As I predicted, this came cheap to Agencies by about 20bps.

Will the liquidity be decent in these FDIC deals? I don't see why not. Will it be as good as Agencies? Not at first. Various funds that have "government" mandates may not be able to buy this paper without some sort of approval from council or a board. That may take a few months, but eventually I think actual "full faith" paper (FDIC) will trade tighter than "implicitly" backed (Fannie/Freddie) paper.

It is entirely possible that the Treasury eventually puts a full faith backing on the GSEs, which would negate the above statement. So I'd say at even spread, I like the FDIC paper. If GSE paper is wider, I prefer the GSE.

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.

Fannie Mae's new Debt: Look at the size of that thing!

Fannie Mae sold $7 billion 2-year notes this morning at Treasuries +70. The deal was oversubscribed. Here are the distribution stats.

US: 63%
Asia: 12%
Europe: 8%
Other: 17%

By type...

54% Money managers
27% Central banks (!!)
19% Other

The 27% Central Bank number is really helping Agency spreads tighten. We're 5-6 tighter, with MBS mildly tighter as well.

Dunno what to say about Lehman. Seems obvious that Fuld has given up the quest to remain independent and is looking for a buyer. That's why they are doing this spin-off of commercial real estate. Once they do the spin-off, then they are basically just a bunch of investment bankers without all the balance sheet ugliness.

Some are skeptical that finding a buyer is possible, but all Lehman needs is someone who has a stronger balance sheet and can take reasonable risks, and the firm can be plenty profitable. It will probably be someone who wants to rapidly increase their presence in the U.S. HSBC has been mentioned, but denied interest. Or Nomura. Either way, someone like that should have interest in Lehman at some price. Remember, it will only take about $4 billion to buy Lehman at current market prices once you take out the commercial real estate holdings.

I'd rather buy Lehman than WaMu. There was a time when several banks were interested in WaMu, but bear in mind that WaMu's whole business is West Coast banking. Maybe J.P. Morgan would still be interested at some price, but you have to wonder JPM wouldn't rather hunt for another West Coast bank with fewer problems. There are accounting issues, which the media has been talking about all day, but forget all that. Do you really think buyers are saying "I'd love to own WaMu, but the accounting is tough." No, I think they are thinking, "I'm not really interested in WaMu, and I'll tell the media its because of accounting."

MBS: Marching into the detention area

While many expected the Treasury to eventually act on the GSEs, few (including myself) expected it to happen over the weekend. So what's the trade in fixed income? There have been four major ideas bandied about Wall Street over the weekend. They are: buy agency debentures, buy agency MBS (mortgage-backed securities), buy credit, and sell Treasuries.

The one I like the most is buy MBS. Yesterday MBS spreads moved dramatically tighter, 55bps in OAS (option-adjusted spread) according to the Lehman index, from +147 to +94. But you haven't missed it yet. For most of the last 10-years, the index OAS has been between 30 and 60bps, so there is plenty of room to tighter further in OAS. I've always felt as though OAS was an over-rated value metric, but today its especially questionable. The Treasury has announced their intentions to buy MBS in the open market, with the clear goal of pushing mortgage borrowing rates lower. Ideally the Treasury would like to set off a refi wave, which would help banks "naturally" delever as well as help separate good loans from bad. In order to get most 2006-2007 borrowers "in the money", mortgage rates probably have to fall to around 5.25%. I think this implies another 50bps of MBS tightening.

Buying agency debentures is less intriguing. Right now non-callable agencies are trading between 50 and 60bps more than comparable Treasury bonds. This spread might fall into the 20's for short-term bonds, but it won't collapse to zero. We don't currently know what the GSEs will look like after 2009, and therefore bonds maturing beyond 2-years shouldn't (and won't) be viewed as truly government-guaranteed.

Credit is highly questionable here. The large-cap financials should benefit significantly from a mortgage refi-wave. This would get the "good" loans off bank's balance sheets, freeing up capital, and clarifying how much each bank truly has in good versus bad loans. But the real catalyst for finance credit will be bank earnings which isn't until next month. Obviously the Lehman situation isn't helping either. Buying new issue bank credits isn't a bad idea as a trade but I'm staying underweight for now.

Non-finance credit makes even less sense. The GSE bailout may have been necessary, but it isn't a panacea for the real economy problems we're facing. I'd stay very high quality within credit.

The direction of Treasury rates is also questionable. There remains significant dollar-related buying, as evidenced by the strong bid for the 10 and 30-year bonds in recent sessions. That is a classic sign of foreign bank buyers, especially given the fact that economically, the yield curve should probably be steeper not flatter. There is also no particular reason to believe the GSE bailout results in dramatically more Treasury supply. Not to mention the simple fact that the economy remains weak which should be a natural support for interest rates. I'm staying close to home on duration.

Nevermind...

Remeber like 4 hours ago when I said it didn't look like anything was going to happen with Fannie and Freddie? Yeah... what I meant to say is that something could happen this weekend! At least that's what the Wall Street Journal is reporting.

Anyway, we'll see what it looks like. I still think that its most likely that the companies have agreed to whatever the Treasury is about to do, so it can't wipe out shareholders. Some capitalist president this dude turned out to be...

Unfortunately, the effect is going to be Treasury rates selling off and MBS rising, which isn't how I'm set up.

Did you catch Bill Gross on CNBC just now? They asked if he had been approached by the Treasury about any government-led solution, presumably asking if PIMCO would participate. Gross said he couldn't comment, which means the answer is yes. Hmm... wonder why no one asked Accrued Interest!?!

Anyway, its possible that this turns out to be a rotation moment, because a bailout of Fannie and Freddie doesn't solve our real economy. It does help prevent it from getting worse, but it doesn't solve anything. But it should help bring mortgage rates down, creating liquidity for financial firms. Could also improve risk aversion, which would help financial firms raise capital or at least sell debt. So we could see a period where financials outperform industrials.

GSE Bailout: Episode III

In recent weeks, a GSE bailout has seemed less imminent. Not because anything is getting better, but because it appears that the Treasury lacks the will to make a move. To be fair, the way the authorizing legislation is written, the Treasury cannot make a move without either the GSEs falling below their capital minimums or compliance by the companies. Based solely on how the company's are valuing their assets and liabilities, their capital position is well above regulatory minimums (especially Fannie Mae).

Now many believe that F&F's asset values are inflated, and perhaps that's true. But what do we expect? Will the government come in and audit the companies, write down their assets and then nationalize? It seems far fetched.

So if there is going to be some near-term action on strengthening the GSEs, it will have to come in a form to which the companies would consent. Ergo, it can't be something that would punish common shareholders.

I think that leaves three options. First would be to do nothing and see how things develop. Let's get back to that one later. Second would be for the Treasury to start buying loans and/or securities from the GSEs to reduce their liabilities. I talked about how this could work here.

Third would be for the Treasury to help the GSEs raise private capital. What if the Treasury agreed to guaranty the principal (not the interest) on a preferred stock offering. The size would be whatever is determined to be needed. In reality it might not be a single preferred offering, but a series of offerings with some pre-determined limit as to the total size.

The preferreds would be callable after 5 years, with the call becoming automatic if the GSEs share price reaches some milestone. The idea would be that if the GSEs are able to issue common equity, then they would be forced to call the tax-payer backed preferred and issue their own securities of some variety.

The Treasury could charge some fee in exchange for the guaranty. Say its an interest rate equal to the 30-year Treasury bond rate, currently about 4.25%. What interest rate the preferred would carry to investors would be determined in the market, but I'd bet somewhere in the 6-7% area.

Here are the advantages of such a plan. First, it could be implemented right away, allowing for stability in the mortgage market and likely a decline in mortgage lending rates. Second, its probably a cheaper plan for tax payers when compared with other options. We know that F&F's new business will be profitable, so if they can be stabilized with a capital injection, the odds that tax payers actually have to shell out any cash is low.

Unfortunately, this kind of solution has a number of problems. First, it creates all kinds of moral hazard, as common equity holders wind up benefiting from the tax payers risk. Currently Fannie Mae and Freddie Mac preferreds are trading with 15% yields, and a new issue, if possible at all, would certainly come at a discount to current levels. So under this plan, the GSEs would be able to issue preferred equity about 500bps cheaper than would otherwise be.

Second, this plan doesn't move us any closer to a more permanent solution to the problem of macro risk and the GSEs. Its a plan that, while easy, doesn't really get us anywhere in the long-term. I suppose such a plan could be an interim step on the path toward full privatization, the idea being to stabilize the market now, buying time for a long-term solution.

Its looking to me like this administration won't do anything about Fannie Mae and Freddie Mac unless they are truly forced to do so. The closer we get to a new administration, the more likely that Paulson waits and lets the next Treasury secretary make the call on the GSEs. So I think we're in for another 6-months of the same with the GSEs. Its always possible that something happens in the interim that diminishes risk aversion and subsequently allows the GSEs to raise capital privately, but I'm not optimistic.

Would I buy agency securities given this outlook? Yes. Senior debt and MBS, but I remain underweight both. I'm probably negatively exposed should a full-on bailout occur. But that's a risk I'm willing to take.

GSE Bailout: Alternative forms of persuasion

The other day I wrote about a possible form of a GSE bailout. In the spirit of stimulating creative ideas, here is another possibility. Bear in mind that its looking more and more like a bailout isn't imminent (meaning its a matter of weeks or months, not days). I expect an interim step, probably some kind of purchase of MBS, to come before any actual injection of cash.

Despite what all the talking heads are saying, no one really knows, maybe not even Henry Paulson, what a bailout will actually look like. But there are ways that a bailout could be structured to both protect senior bond holders and help prevent the need for another bailout in the future. Now is a good time for people with good ideas to come forward.

First we have to consider what the goal of a bailout should be. In this case, its very simple: ensure liquidity to the mortgage market. This protects banks which have committed to home loans assuming one of the GSEs would buy them. This also keeps mortgage borrowing rates stable.

Beyond that though, there needs to also be some long-term solution to the GSE situation. Fannie Mae and Freddie Mac cannot return to business as usual. Another structure needs to be devised that reduces the systemic risk surrounding the mortgage GSEs. On the other hand, a simple "demonstrable privatization" is not a near-term solution either. Currently Fannie Mae, Freddie Mac, and Ginnie Mae are the only thing standing between here and absolutely zero market for home loans.

Many solutions being bandied about presume the long-term model for mortgage securitization remains in tact. But why? A big part of the inherent problem in the GSEs' current business model is that it requires substantial leverage to generate a reasonable return on equity. Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie's guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in tact.

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We'd wind up with large banks dominating the mortgage market, which has its own systemic risk problems.

So what if in the future the GSEs provided some limited guarantee on covered bonds? Remember that a covered bond is backed both by the credit of the issuing bank as well as a pledged pool of mortgages. So in order for anyone to take a loss on a covered bond, the bank would have to be bankrupt and mortgages would have to be defaulting.

Let's say the newly recapitalized GSEs are restructured more like an insurance company, where the GSEs would guarantee to investors some percentage of par, say 95%. Banks would remain on the hook for losses within the pledged pool as long as the bank itself remained solvent. But in the event that the bank goes under, covered bond investors would have a known limit on their losses. The GSE would also have contained costs, since in most cases the pool of mortgages which had originally secured the covered bond would have some residual value.

This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

That leaves what to do with the old GSE guarantee portfolio. Assuming the Treasury has infused Fannie Mae and Freddie Mac with new capital, those portfolios could simply be allowed to run off. Alternatively, the Treasury could require the new GSE to buy preferred shares of the old Fannie and Freddie, helping to offset tax payers costs. Eventually this new GSE could be "demonstrably privatized" as market confidence is regained.

GSEs: No takeover this weekend

Merrill Lynch is telling clients that a source within Treasury says they want to keep the GSEs in their current form, as in shareholder owned. That implies no "takeover" any time soon. It also implies that some alternative to a full blown takeover would be the first step.

I'd say that tells me that Treasury buying MBS is very likely in the near term.

What Treasury needs to do is simply give the market a plan. What if they came out and said "If either or both of Fannie Mae or Freddie Mac's capital ratios fall below the regulatory minimums, the Treasury will [insert plan here]" The plan would spell out where the Treasury's investment would be, which would give some picture to all investors in any part of the capital structure.

The market doesn't care what happens to GSE common holders. The market needs some visibility about the possible outcomes.

GSE Preferreds: I don't believe it!

Fannie Mae and Freddie Mac preferred stocks rose ~$3 in the last hour of trading. Yes you read that right. Something like 25% off the lows of the day to finish some 10-15% higher for the session.

I couldn't find anyone who knew why, but all the traders I talked to suggested it had a certain "The Dukes know something!" feel to it. Who knows. Shit like that happens all the time. Sometimes someone actually knows something. Sometimes its just a very thin market and someone just thinks they know something. Anyway, theories are welcomed.

That bad huh?

CDS trading is looking real panicky this morning. Lehman is 40ish bps wider, other brokers 20 wider. Zero liquidity. Swaps wider again, although mildly. Fannie and Freddie senior spreads unchanged. MBS look slightly wider after finishing basically unchanged yesterday.

Dow currently down less than 100 points. Financials down ~2%. That ain't gonna be enough. I wouldn't be surprised if we suffer through another 200 point day.

The market continues to obsess about housing starts, which is a completely worthless statistic here. I'm looking at housing sales and delinquencies as the key stats.

UPDATE
FRE and FNM preferreds are down another 20% or so today, threatening the $10 area on FRE Z. One trader told me he's started to see bottom fishing here, which seems incredibly stupid to me. Bottom fishing can work as a strategy, but no one can put odds on whether the impending GSE nationalization will make preferred shareholders whole or not. This isn't about financial analysis anymore. I'd rather bottom fish in WaMu or Lehman or National City any day. At least those are actual businesses where management will be making every effort to survive. Fannie and Freddie are going to get taken out regardless of how the housing crisis plays out from here.

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.

The GSEs: Even Yoda cannot see their fate

This is a bond market blog. Fannie Mae and Freddie Mac are dominant players the bond market. Not only are they the biggest non-Treasury issuers of straight debt securities, mortgage-backed bonds guaranteed by the two mortgage giants represent over 30% of the total taxable bond market. Therefore the problems at the GSEs probably touches just about every investor directly in a way few other companies would.

While delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae), the fact is that both companies employ tremendous leverage, and therefore losses even mildly above historic norms are likely to put huge pressure on the company's equity. In addition, Freddie Mac is yet to complete the $5.5 billion capital raise they promised in May, and given market conditions, this will be all but impossible without government intervention. So I'm not here to challenge the plunging share price of either Fannie Mae or Freddie Mac.

I also don't feel like commenting on the bailout plan, other than to say that its a sad day for free markets. I see the Treasury as between a rock and a Depression, and has selected the rock. I'd have done the same. I don't blame Treasury so much as I lament that its come to this. Exactly who to blame for this or what could have been done differently in the past is a discussion for another time.

There are two somewhat unrelated things I want to comment on. First is this stupidity about FAS 140. FAS 140 has nothing to do with anything. Or at least, it should have nothing to do with anything. An upcoming revision to FAS 140 will tighten the rules about off-balance sheet accounting. Based on how both GSEs currently operate, this would probably require both Fannie Mae and Freddie Mac to bring their guarantee portfolio on balance sheet. Under current statues, the GSEs minimum capital required is 0.45% of of their guarantee portfolio and 2.5% of their aggregate on-balance sheet assets. So taken literally, the GSEs capital requirements would increase dramatically if their entire $4.5 trillion guarantee portfolio were brought on balance sheet. The commonly reported number is $43 billion for Fannie Mae and $38 billion for Freddie Mac.

Of course, its ridiculous to think that regulators would allow an accounting rule change to dictate the GSEs minimum capital. Economically the GSEs are no more or less safe whether this stuff is on balance sheet or off. Its especially ridiculous given that a capital infusion of that level would be impossible to achieve in almost any market, much less now. And the GSEs alternative would be to sell massive amounts of MBS on their books, which would benefit exactly no one. Indeed OFHEO director James Lockhart has said point blank that FAS 140 should not apply to the GSEs and that accounting changes would not drive a capital change.

The second is where we should go from here with the GSEs. I will ignore what the Libertarian in me would like to see and thinking about what could happen. In other words, we should take it as a given that the base mission of the GSEs will remain as is. Congress wants to see some entity out there which can promote home ownership and help stabilize the mortgage market.

My idea would be to break up Fannie Mae and Freddie Mac into several, smaller entities. Say we make it 10 different companies, which I'll just call the "Macs." The $4.5 trillion guarantee portfolio would be divided equally among the Macs, not by geography, but more or less randomly, with some effort made to be sure the quality of each loan portfolio is roughly the same.

All of the Macs would be given a credit line with the Treasury equal to 10% of their guarantee portfolio. Any amounts drawn on the line would be at some small spread to LIBOR, say 3-month LIBOR + 20bps. This would in essense ensure liquidity at each of the Macs while at the same time giving them a strong incentive to use private funding, which would almost certainly be at a better rate than LIBOR +20. Note that historically, Fannie Mae and Freddie Mac debt has traded at LIBOR minus 20 or so.

The Macs capital adequacy could be managed more like a bank's. And there would be a stipulation that if the Macs capital fell to a certain level, the Treasury would take over operations, not unlike the FDIC taking over a failing bank. There could then be something similar to a bankruptcy procedure, but with the Treasury credit line ensuring that some mass contagion did not ensue.

What's the advantages here? First of all, no one Mac would be too big to fail. If one of the Macs f'ed up their hedging or some such, the government could liquidate shareholders relatively easily. Second, there would be a more known procedure for what happens in event of a Mac failure. Third, having several Macs would encourage competition among them, which would probably drive mortgage rates down. As it is, Freddie and Fannie are dictating terms of the mortgage lending business.

Now I know this isn't a complete plan, but I'm interested to hear comments on what we should do with the GSEs. I encourage everyone to remain within the realm of realism. There will be such a thing as a GSE in the future. So let's consider what they will look like.

Maybe it's another drill

This is the first time in my career that I truly believe U.S. Treasury bonds sold off on credit concern. By this I mean, the credit of the U.S. Government. Long time readers know I'm not an alarmist type, and I'm sure not saying the United States is going belly up, but credit default swaps on the United States of America moved 11bps wider today (from 9bps to 20bps). The 10-year Treasury moved 15bps higher. All on a day when people are scared shitless and there should have been strong demand for "risk-free" assets.

Draw your own conclusions. I've drawn mine.

Clumsy and Random Thoughts

• It is feeling very panicky right now, in that the market is moving suddenly and without proximate reasons. Unfortunately, the panic is legitimate. No one knows what a GSE bailout will look like.
• But you shouldn't conclude that a bailout would be difficult. Read this post. I stand by everything I said then.
• There are also rumors that PIMCO and SAC were not trading with Lehman. Both PIMCO and SAC have denied the rumor. Worth noting that PIMCO was one of the first to stop trading with Bear Stearns. Anyway, neither has reason to deny the rumor other than that the rumor isn't true.
• The more panicky things get, the more likely we get a relief rally after bank earnings are out. Odds are good that it will be a mixed bag, with some banks looking particularly ugly (Wachovia this morning warned of a huge loss) and others will be bad but not that bad. I mean, take a look at short interest on the NYSE...

• That being said, I don't think we can get a sustained rally (in credit or equities) until the market thinks it knows the outcome of both bank capital raising and home price declines. Now that will happen before housing has actually bottomed, because the market will look forward and conclude the worst is behind us.
• So I'm still vastly underweight credit generally and financials specifically. I've cut duration in an attempt to play a post-bank rally, but I'm just too chicken shit to buy a bunch of bank paper here.

Rumor of the day

Apparently today's sudden sell-off (rally in bonds) has something to do with Fannie Mae and Freddie Mac. Both stocks are down ~25%, MBS are getting crushed (FNCL 6% underperforming the 5-year by close to 3/4 of a point) and even agency debentures are 5-ish wider. Pretty big single-day move. The 2-year Treasury went from 2.55% to 2.36% in about 10 seconds. Now that's a flight to safety!

Its also obvious rumor mongering. Haven't heard any specific rumor of earnings pre-announcement or anything like that. Both companies don't report until August. I'll post what I hear.

Update:
Hearing that one of Freddie Mac's top 3 shareholders either has or wants to dump his shares. FRE/FNM CDS are 80bps senior and 200bps subordinate, the former is 13bps wider on the day and the later about 23.

Update #2:
The main-stream media has been citing a Lehman research report discussion the adoption of FAS 140, which according to the report would require $46 and $29 billion of capital for Fannie Mae and Freddie Mac respectively. Say what you want about FAS 140, but the Lehman report is absolutely positively not why the market is moving today. First of all, the report want issued early this morning. The sell-off really got going in the early afternoon. Second, the Lehman report is bullish on the GSE's stocks! From the report...

"One issue we want to focus on in this report is a pending FASB rule change, the outcome of which could be so contrary to all other current capital ratios and policy initiatives that we cannot imagine such an outcome occurring."

and...

"But at these prices we are sticking by our view that the NPV of the GSEs' profit growth and intrinsic franchise value should produce returns that make today's price look compelling."

Looks like bank and broker CDS can't catch a bid despite the FRE/FNM story. Also 2-year swaps, which initially pushed 3bps wider just as the GSE's were cratering is now about 1/2 of a bp tighter. Don't read that as indifference about the GSE's, read that as what can happen when a trade becomes uni-directional.

MBS spreads were as much as 20bps wider on the day, now only 7. Straight agency debt still about 5-8 wider. FRE/FNM CDS in the same context, maybe 2-3 better than the wides.

If you care, here is my view on a GSE bailout, basically that it would most likely take the form of direct government-backed debt, as opposed to some huge outlay of cash. It will happen if it comes to that.

That thing's operational! (More on the GSE's)

Yesterday's post on the GSE's garnered a lot of great comments and I wanted to answer some of them in a new post, as I know the majority of Accrued Interest's readers come to us via RSS or e-mail. I'm not going to hit them all, but I'd encourage you to read all the comments for yourself.

First, I made some overly simplistic, and partially just plain wrong, statements about Freddie Mac's debt/asset situation. Read about that in a note at the end of yesterday's post.

Another persistent question is whether the GSEs would be solvent right now if not for the implicit support from the Treasury. Its an interesting question to ponder, but impossible to answer completely. That's because we don't know what the GSE's would look like if they didn't have government support. In other words, Fannie Mae and Freddie Mac would look very different today had they been founded as private companies and/or had the Treasury cut ties with them many years ago. They'd likely be a lot smaller, and probably would have focused in higher margin products. You know, like sub-prime.

But for the hell of it, let's consider the GSEs' solvency with the only variable being the market perception of government support. So we're holding their portfolio composition, loss situation, funding strategy, overall size, etc. all constant. What would that look like?

I'd say the closest parallel are mortgage insurers, like PMI and MGIC, in terms of access to capital. MGIC recently did a preferred equity offering, but generally speaking those firms would have a hard time doing straight debt offerings right now. Fannie or Freddie would have a couple things going for them, when compared with the mortgage insurers. The mortgage insurers' primary exposures are where the borrower didn't put 20% down. A portfolio like that is clearly riskier than Fannie Mae or Freddie Mac's. Freddie Mac's CLTV is 67%. Now there might be some silent seconds that they aren't counting, but still, its assuredly better than a straight mortgage insurer.

We know that the GSEs have recent done preferred offerings to raise capital. Would they have been able to complete those transactions without government support. Maybe, but surely not at the levels they got. See the terms of MGIC's convertible offering from April 1.

So I'd guess that they would be solvent, but it would be close. Damn close.

Would a government bailout be just too expensive, even for the Treasury? I don't think so. I think the Treasury could just directly guarantee their debt, (see Chrysler) which would have limited direct costs to the Treasury. Or they could simply have FHA buy a chunk of bad loans from the GSEs. There are several ways to work a bailout of the GSEs. I believe very strongly that tax payers are married to the GSEs, for better or worse.

Did Freddie Mac move their ABS portfolio into Level 3 because they didn't like the bid indications they were using for valuation? The company says no. Here is the quote from their earnings conference call:

Q: (From Paul Miller of FBR) ... There is a headline out there, talking about Freddie Mac Level 3 assets of $157 billion and I don't see that in any of your releases. I was just wondering is that true... and is that related at all to the markups of the trading securities...?

A: (Buddy Piszel, CFO) No, it is not Paul. We made a determination in the first quarter, that given how widely the pricing we were getting on the ABS portfolio, that it no longer made sense to leave that in Level 2.... We were still using the mean price that we were getting from the pricing services and the dealers. So we are not using a model price.... It has nothing to do with the trading portfolio.

So if you believe what he's saying, that means that the actual valuation would be the same either way. By moving to Level 3, they are saying they no longer believe the valuations represent "observable inputs."

What about mortgage insurers? Freddie has as presentation on this from March. I think the way to think about GSEs and MI is similar to a municipal bond portfolio and the monoline insurers. Losses will be a function of both the MI going down and the actual borrower going down. Plus the GSE would have a claim on the MI in run-off. On the other hand, MI exposure is substantial and should any of them go bankrupt (a strong possibility) it absolutely could result in considerably higher losses at the GSEs.

Finally, what's the "end game" here? Here is what I think we know. We know that new business written by the GSEs can be profitable, if loss rates on 2008 vintage loans are even close to historic norms. We also know that the real cash losses on the GSE portfolios are just beginning. Freddie Mac predicts their credit loss rate will double by 2009. The good news is that they've reserved for that. The bad news is that there are a hell of a lot of variables to those loss numbers.

So whether or not the GSEs can remain in business (without help) comes down to credit losses and access to financial markets. If the GSEs can keep raising new capital, there won't need to be any bailout orchestrated by the Treasury. I think that's the best tax payers can hope for.

How Safe are the GSE's?

Freddie Mac's earnings release from last week created quite a buzz. It was initially viewed as an unmitigated positive, but upon further review, we all realized Freddie's accounting is too opaque to draw any reasonable conclusions.

I do feel that there have been some mischaracterizations of reality around the blogosphere, and I thought Accrued Interest could help shed a little light on the situation. So here is a little Q&A on what this development really means to real investors.

Q: Freddie Mac is actually insolvent, right? I heard they had negative net worth.

A: If you define insolvency as negative net worth on paper, then yes. I don't know to whom such a calculation is relevant. Its a quirky statistic that is emblematic of their recent woes. But it isn't relevant to investment valuation.

Q: But if they are insolvent, that would mean the tax payers might have to bail them out!

A: Tax payers will have to bail out the GSE's if it comes to that. I have no doubt about that. But it only will come to that if the GSE's cannot fulfill their function as liquidity providers to mortgage originators. Right now that isn't a problem, despite the negative net worth.

One could argue that the GSE's are only able to fulfill that liquidity function because of implicit government support. I think that's probably true. But if you believe that, then it wouldn't matter how much money the GSE's lost as long as the market believed in their government support.

Q: Freddie Mac's senior debt rating is still AAA, which is about as much bullshit as Ambac. How can these guys keep losing money quarter after quarter and retain that rating?

Actually, through the miracle of subordination, debt holders are probably relatively safe, even without government support. To be sure, there is no way either GSE would earn a AAA rating without the implied government support. But consider the debt/asset situation at Freddie Mac:

Total Assets: $786 billion (eliminating their deferred tax asset)
Total Senior Debt: $755 billion
Total Sub/Preferred Equity: $19 billion

So in order for senior liabilities to be greater than assets, the asset pool would have to decline by about 4%. Freddie Mac's credit loss was at a 12bps rate in Q1 and their forecast is 18bps in 2008 and 20-25bps in 2009. Take the company's estimates with whatever brand of Kosher Salt you like, but consider the odds of them being wrong by a factor of 16. (See note at the end of this post)

Q: You just want to be lied to, don't you? How can you trust any of their asset valuations anyway? I heard its all Level 3 assets!

A: They have $157 billion in Level 3 assets.

Q: Every one on my message board knows that Level 3 assets are toxic waste. That would more than make up your 4%!

A: First of all, the concept of Level 1, 2, and 3 assets stems from FAS 157, which is summarized here for those who like primary sources. The idea was to categorize the means by which assets have been valued by management. Level 3 assets are those that have been priced using "unobservable" inputs.

Q: Aha! Unobservable means mark-to-make-believe!

A: Part of requiring the Level 3 disclosure was to allow investors to consider how much they want to trust asset valuations based on models, especially in a market like this. So if you want to discount the valuation of Level 3 assets, the new disclosure allows you to do so.

Q: OK, so how much should I discount the assets? 100% or just 80%?

A: Unfortunately, there is some debate as to what constitutes an unobservable input. In Freddie Mac's case, they had classically valued their ABS portfolio by getting dealer quotes, and therefore believed that suggested a Level 2 designation. However given the wide variance in dealer quotes, Freddie decided to move the assets to Level 3. I'd think of it this way: if the model inputs being used by dealers were "observable either directly or indirectly" (Level 2) it stands to reason that the various dealers would have similar observations, and thus similar prices. Since they didn't have similar prices, you have to conclude the model inputs are not readily observable.

Q: Sounds like you are leaning toward 100%.

A: The reality of the bond world isn't that simple. The fact is that the overwhelming majority of fixed income instruments rarely trade. Therefore almost all bonds held on any company's balance sheet are valued by a model. For that matter, bonds that are held in your run-of-the-mill investment-grade mutual fund are similarly valued by model. One could make a case that a very wide swath of bonds are valued with "unobservable" inputs.

For example, there are 1,082 tax-exempt municipals bonds rated below investment-grade by Moody's. Of these, only 307 have traded any time this year. Now I grant that there is some correlation among junk-rated muni spreads, but how comfortable would you feel about the valuation of some struggling nursing home deal in Wisconsin by examining the trading level of a convention center in Texas? According to the FASB "Adjustments to Level 2 inputs that are asset specific... might render the measurement a Level 3 measurement." Sounds like the valuation of rarely traded municipals would fall into Level 3.

Q: But Freddie Mac is getting their quotes from dealers! And Freddie Mac is one of the 5 or so best accounts to have as a bond salesman. The dealer firm is obviously biased.

A: Granted. But what's the alternative? You are talking about positions for which there is no trading market. The best you can do is ask someone what they might pay for it, and value it that way. Its biased, but the alternative would be for Freddie Mac to create their own model. Can you imagine the outrage on the interweb if that's how they valued their positions?

Besides, I'd bet that Freddie Mac thought that getting quotes from dealers was the only way to avoid Level 3 designation. Asking for a theoretical bid from a dealer could reasonably be considered an "observable input" thus allowing a Level 2 categorization. Only when it became obvious that the dealer community had no idea what to bid did Freddie move the assets to Level 3 designation.

Q: So when the dealer quotes were too low, Freddie changed their methodology! Its Enron all over again!

A: Actually Freddie Mac didn't change their methodology, merely moved their ABS portfolio into Level 3. They always valued their positions with dealer quotes. You are better off not obsessing over the Level 3 assets themselves, but rather the fact that no one seems to know what Freddie's assets are actually worth.

Q: I still don't trust their accounting.

A: Neither do I. Its clear that derivative accounting according to GAAP doesn't reflect the reality of Fannie Mae or Freddie Mac's business. My best guess is that Freddie's recent figures were aided in a non-economic way by accounting practices. But who knows? I really don't feel like I have a good handle on it.

And guess what? I'd feel exactly the same way if they had zero Level 3 assets.

So what's the point here? Any financial firm involved in fixed income securities and related derivatives is likely to have significant Level 3 assets. Reflexively assuming this means the firm is involved in shady securities is lazy analysis. The hysteria over Freddie's Level 3 assets is misplaced. Thoughtful analysis as to why Freddie Mac felt compelled to move their assets into Level 3 is what's needed. Its a little spooky to consider that Freddie Mac can't get a good value on their securities, that their dealer evaluations varied so much. That's the more important point in analyzing Freddie's balance sheet.

Note
This calculation as presented here is not entirely accurate, primarily because I erroneously equated the credit loss percentage as if it were a percentage of assets, but in fact it is a percentage of Freddie Mac's guarantee portfolio. That's what I get for trying to put together a back-of-the-envelope example, but there is no excuse for publishing something like this.

I probably shouldn't have included the example at all, as it was a very simplistic calculation, and honestly, it probably took away from my bigger point that FRE and FNM's accounting is a mystery. I mean, I tried to argue the opacity of their books, then I used their books to make a point.

On top of that, I quoted their credit loss percentage of their guarantee portfolio vs. their asset base, which was totally wrong on my part. My idea was to value the company's debt from an asset liquidation perspective but the introduction of the credit loss percentage wasn't the right metric.

The more accurate way to look at it is that the company expects $3.1 billion in credit losses in 2008 vs. the gap between assets and debt of $31 billion. So if you imagine credit losses as requiring cash to flow out the door, we'd need 10x the 2008 credit loss level (with no positive cash flow in the interim) for the debt/asset ratio to fall below 1.

Now that could be coupled with losses in their investment portfolio. That's an area that's difficult to forecast, because I just don't know whether they've properly written down their assets or not.