search CFD Spy


Most Popular

got trading broker knowledge? Why not Submit a rating and review today!
Compare Online Trading brokers

1 Star2 Stars3 Stars4 Stars5 Stars
(6 votes, average: 4.33 out of 5)

August 24th, 2008, 10:11 pm | By Lunch is for Wimps | Published in LUNCH IS FOR WIMPS | Comments on this post1 Comment »

The ailing US mortgage giants Fannie Mae and Freddie Mac are going to be bailed out by the Treasury. That much seems certain. But Henry Paulson should act now – while there is still something to save besides the US housing market.

Fannie Mae and Freddie Mac were designed to inject liquidity into the US mortgage market. They do this by buying mortgages from banks and using them as collateral to fund through mortgage-backed securities (MBS).

With their government backing – once implicit but now about as explicit as a snuff movie from Jeffrey Dahmer’s private collection – they have been able to fund at very cheap levels in the MBS market. This difference in the interest paid on what they own and what they owe has made them handsome profits in the past.

It all worked fine when the housing market was thriving but last summer that market turned nasty. This happened about the time that subprime borrowers in the Deep South were given 150% mortgages to buy 11-bedroom mansions, and no-one wondered how they could ever pay them back.

After the subprime mortgage crisis hit, investors, bankers and lawmakers realized that the government sponsored entities (GSEs), owning about half of the $12 trillion mortgage market, may have over-extended themselves just a wee bit.

But that dominant position meant that the US government had no choice except to bail them out. Last month, the Treasury extended credit limits to the firms and got permission from Congress to buy stock. That led to a rally of about 50% in the stock prices of both Fannie and Freddie.

But what has happened since then? Nothing! Nothing good anyway. Both GSEs posted unsurprising first-half losses and cut dividends earlier this month. Subsequently, any previous gains in their stock prices after the Treasury’s announcement were wiped out.

That’s a shame. By standing on the sidelines, perhaps encouraged by the stock price jumps after its announcement, the Treasury lost the initiative – and damaged shareholders in the process.

Arguably the shareholders should be left to fry. They knew what they were getting into when they bought their clips of Fannie and Freddie. Or at least they should have. Despite all the implicit guarantees and the government “sponsorship” Fannie and Freddie were listed companies which could, in theory fail – never mind take a beating in the stock market. But as the stocks fall, it is not just fund managers and small-time investors who feel the pinch. A much more important group gets hurt too: the debt holders.

Between them, the two mortgage insurers owe about $1.5 trillion of debt and are counterparties to around $2.3 trillion of derivatives contracts. That’s a significant chunk of change. And as their stock prices have fallen, the costs of insuring against their default – expressed by credit default swap (CDS) prices – have ballooned.

The more their CDS levels rise and their bond prices fall, the larger write-downs firms which hold their debt will have to take. But the bonds won’t default. The government will step in. So as long as they wait the investors will be fine, right? Wrong.

The government will step in, sure. And even if, as is likely, senior investors get their money back eventually – and I haven’t even touched in this post on the thorny topic of the subordinated debt holders – in the meantime those senior investors will have to set aside capital against their investments which could be put to better use elsewhere. Those so-called risk provisions eat away at capital that is sorely needed.

We are in the midst of a sweeping tornado of financial ruin. Now is not the time for Hank Paulson to scratch his head while fears, and write downs, spiral. Get the job done now, Hank. It’s not just the housing market you need to save. Look around you – the whole financial system needs saving.

Be Sociable, Share!

About the author

Lunch is for Wimps Lunch is for Wimps used to trade currencies and equity indices – and even occasionally traded German government bonds when he was trying to cure insomnia. Watching Wall Street one night, he heard Gordon Gekko deliver the classic line: “if you want a friend, get a dog”. Unfortunately, a large build-up of ear wax led to him mishearing this piece of wisdom, and he ended up starting this damn blog when he should have been at the pet shop instead.

You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

One Response to “Get a move on Hank, GSE investors need you now”

  1. Please keep these excellent posts coming.