Page 3 of 4 Debt capitalism self-destructs
By Henry C K Liu
Still, the Office of Federal Housing Enterprise Oversight (OFHEO), the
regulator of these GSEs, declared them as adequately capitalized in regulatory
terms. The companies' existing congressional charters give the Treasury the
authority to buy as much as $2.25 billion in each of their securities in the
event of possible default, against a total liability of over $5 trillion. The
works out as an equity injection of less than half-a-cent on each dollar of
liability.
Credit-default swaps tied to the senior debt of Fannie Mae and Freddie Mac have
climbed 35 basis points to 70 basis points since May 1, 2008. A basis point is
0.01 percentage point. The cost to protect the companies' subordinated debt
from default
rose at a faster rate. That debt is rated Aa2 by Moody's. Credit-default swaps
on Fannie Mae's subordinated notes jumped 103 basis points to 190 basis points
since May 1, while contracts on Freddie Mac's subordinated notes rose 102 basis
points to 190 basis points.
The median credit-default swap on debt rated Aaa by Moody's was 26 basis points
as of July 8. It was 76 basis points for debt rated A2, and 180 basis points
for debt rated Baa3, the lowest investment-grade ranking. The costs likely
reflect counterparty risk, or the risk that the bank or securities firm on the
other end of the contract fails. For most companies, the counterparty risk
embedded in credit-default swap costs would not be as pronounced because the
risk of a default on the underlying debt would be greater than that of the bank
backing the protection. In the case of Fannie Mae, Freddie Mac and other
companies with Aaa ratings, the default risk for lower-rated banks is greater.
Credit-default swaps are financial instruments based on bonds and loans that
are used to speculate on a company's ability to repay debt. They pay the buyer
face value in exchange for the underlying securities or the cash equivalent
should a borrower fail to adhere to its debt agreements. A rise indicates
deterioration in the perception of credit quality; a decline, the opposite. A
basis point on a contract protecting $10 million of debt for five years is
equivalent to $1,000 a year.
In the US, where loan
securitization is widespread, banks are tempted to push risky loans by passing
on the long-term risk to non-bank investors through debt securitization.
Credit-default swaps, a relatively novel form of derivative contract, allow
investors to hedge against securitized mortgage pools. This type of contract,
known as asset-back securities, has been limited to the corporate bond market,
conventional home mortgages, and auto and credit-card loans. Last June [2005],
a new standard contract began trading by hedge funds that bets on home-equity
securities backed by adjustable-rate loans to sub-prime borrowers, not as a
hedge strategy but as a profit center. When bearish trades are profitable,
their bets can easily become self-fulfilling prophesies by kick-starting a
downward vicious cycle.
The US charter and the GSEs' role in
guaranteeing about 46% of the $12 trillion US mortgages outstanding led to
expectations that the government would stand behind the agencies' debt.
Standard & Poor's assigned the debt top ratings, citing the agencies'
"explicit and implicit support" from the government.
Moral hazard effect
The bailout of Bear Stearns Cos arranged by the Federal Reserve in March
signaled to the market that the government would not allow the GSEs to fail or
default on their debts. It is clear evidence of the moral hazard effect on the
financial market from bailing out one institution. With all the exposure that
all banks and non-bank institutions and central banks have to Fannie and
Freddie debt default, the ripple effect through the whole financial system
would be unbelievable if they were allowed to fail. It was also clear evidence
of the "too big to fail" doctrine.
The risk surrounding Fannie Mae was reflected in the GSE's latest sale of $3
billion of two-year benchmark notes at higher yields over benchmark rates than
in previous offerings. The 3.25% notes, which mature August 12, 2010, priced to
yield 3.27%, or 74 basis points more than comparable US Treasuries. The company
in June 2008 sold $4 billion of 3% notes maturing July 12, 2010, that priced to
yield 3.036%, or 65 basis points more than Treasuries.
The government has been leaning on the GSEs to help revive the home mortgage
market. Congress lifted growth restrictions on the companies, eased their
capital requirements and allowed them to buy bigger, so-called jumbo mortgages,
to spur demand for home loans as private lenders fled the market. The decision
to use Fannie Mae and Freddie Mac as part of a $300 billion housing stimulus
plan strengthened perceptions of the government's support of the GSEs. Their
share of new conforming mortgages, or loans of $417,000 or less, almost doubled
to 81% in the first quarter of 2008, according to the Office of Federal Housing
Enterprise Oversight (OFHEO), the regulator. It appears that the fire engines
caught on fire on its way to the scene of the fire.
Merrill Lynch analyst Kenneth Bruce said in a report that the "highly levered
financial institutions" would have pretax credit-related losses of $45 billion,
suggesting that Fannie and Freddie are going to have to raise more capital, but
the market does not think they are going to be able to raise capital when they
need to at a cost they can live with. The New York Times reported on the night
of July 13, 2008 (Sunday) that discussions among senior US government officials
had heated up with respect to the US taking over Freddie Mac and Fannie Mae
before markets opened in Asia. The structure being contemplated is a
"conservatorship", which is permitted under a 1992 law and is one that would
essentially wipe out the two GSEs' respective equity while allowing their loans
to be managed.
Conservatorship is another fancy term of nationalization. The scheme allows the
government to pretend the GSEs' liabilities are not its own even after it
assumes them. A finding from the Office of Federal Housing Enterprise
Oversight, the enterprises' regulator, that the GSEs are "critically
undercapitalized" would be needed for conservatorship application. Up to now,
the OFHEO has sent out the opposite message to the public. It will have to
announce a 180-degree "correction" to shift quickly from "adequately
capitalized" to "critically undercapitalized" for the government's proposal to
work.
But unlike 1933 in the days of the New Deal when deficit financing was an
operative option to revive the economy because the government was relatively
free of debt, the US in 2008 is already deeply in debt, having operated with
deficit financing in a boom time for more than two decades. Estimates suggest
that for each 10% decline in Freddie/Fannie assets value, a loss of $150
billion would result, equivalent to the cost of the Iraq War to date. And
Fannie has lost 80% of market capitalization and Freddie has lost 70% to date.
Soaring government obligations
By assuming the GSEs' combined $5 trillion in liabilities, the US government's
total obligations would soar from $9.5 trillion to $14.5 trillion. This will
raise the per capita national debt from $31,250 to $47,650. The added debt is
one and a half times the Bush Administration proposed 2008 fiscal budget of
$3.1 trillion. While the agencies own housing-related assets that roughly match
their liabilities, the still-collapsing housing market makes their value
uncertain. This will unavoidably force the dollar to fall and dollar interest
rates to rise. Meanwhile, the turmoil is impeding or even paralyzing the GSEs
in their crucial life-support role for the housing market.
An analyst's early July report from Lehman Brothers, an investment bank itself
on the brink of collapse, provoked the market panic over the GSEs. Lehman, a
major player in the mortgage-backed securities market, lost as much as 20% in
intraday trading on talk that PIMCO, the world's largest bond trader, no longer
was conducting business with the Wall Street firm. Then William Poole, a
respected former chief of the St Louis Federal Reserve, now a private
investment advisor since July 1, 2008, observed that Fannie and Freddie were
technically insolvent in the first quarter this year on a mark-to-market basis.
Such information was not news - in a 2006 speech, Emil Henry, then a Treasury
assistant secretary, likened a failure of one of the GSE companies to a "single
gunshot setting off an avalanche" - and had no bearing on the GSEs' solvency in
regulatory terms. Yet the new unsettling attention on two market leaders of
overwhelming scale in an uncertain climate threw financial markets into a
downward spin.
Fannie and Freddie were the original inventors of mortgage-backed security, a
key cause of the housing bubble and its subsequent deflation. These GSEs
received credit and recognition for ingenuity in unbundling risk and reselling
mortgage-backed securities to buyers of varying risk appetite in the global
market. It was the secret behind the US housing boom and the enabling idea
behind the structured finance market. Alan Greenspan, former Federal Reserve
chairman, praised it ceaselessly as an ingenious breakthrough that did much to
widen home ownership. But the development weakened the mortgage originators'
oversight of loan quality.
Greenspan accepted the risk as part of the natural phenomenon of "bad loans are
made in good times". The backing of the GSEs enabled securitization of "ninja"
mortgages (no income, no job or assets), loans that no one would buy if they
were not guaranteed by the government. Thus the fault did not lie with mortgage
originators, for they would not be able to issue shaky mortgages unless there
was a market for them. GSEs' abuse of their alleged government guarantee had
rendered market discipline inoperative, allowing the system to go on a wide
joyride that was bound to crash of a cliff. Because of their complexity and
broad distribution, when securitized debts default, restructuring is almost
impossible. There is no effective fire break once the fire begins and quickly
engulfs the whole market.
The sooner the need for a systemic restructure is acknowledged and acted upon,
the better it would be for the long-term health of the economy, or the future
of regulated market capitalism itself. However, hybrid solutions of quick fixes
to paper over seismic financial faults are being proposed to enable the evasion
of responsibility and for political advantage in an election year.
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