PrefBlog

Yesterday, Citigroup was reported to have advised that Fannie & Freddie aren’t dead yet. Today it was Merrill’s turn:

Merrill Lynch & Co. analysts said a bailout of the mortgage-finance companies is “premature” because losses won’t cause capital to deplete for several quarters.
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The market may be premature in expecting a rescue is imminent because the companies may not need to raise more capital to meet current requirements, the analysts said.

It’s not clear that Fannie and Freddie “need a capital injection,” [Kenneth] Bruce and [Cyrus] Lowe said in two separate reports. Still “policy makers may be forced by the controversy playing out in the market to consider various options to stabilize” the companies.
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The two mortgage-finance companies “will likely be plagued by poor visibility into the future of credit losses and the uncertainty surrounding the possible public policy actions that could jeopardize shareholders,” the analysts wrote. “Risks of further contraction in the mortgage market are as unpalatable as a high-profile bail-out.”

Both stocks are rated “underperform” at Merrill, the reports said.

Fannie & Freddie sold some more money market paper today:

Investors have been watching the debt sales for any “tell- tale” signs that Washington-based Fannie and McLean, Virginia- based Freddie can’t fund themselves, UBS AG analysts in New York including William O’Donnell wrote in a report. Today’s spreads were wide enough to attract demand, yet narrow enough to dim speculation that the government-sponsored enterprises will be forced to turn to Treasury Secretary Henry Paulson for support.
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Fannie sold $1 billion of three-month notes at a yield of 2.58 percent, the company said.
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Freddie raised $1 billion of one-month debt at a yield of 2.28 percent, or 66 basis points more than Treasuries and 18 basis points less than one-month Libor, separate data shows.
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Fannie also sold $1 billion of six-month debt today at a yield of 2.87 percent, about 93 basis points above Treasury bills

Geez, I wish that reporters would learn some of the jargon of the trade! I was all excited about the “short term notes” headline – indicating a 1-5 year term – only to find out it was money-market paper.

Assiduous Reader prefhound noted in yesterday’s comments:

You noted the other day that they needed to rollover about $120B of debt in the next 35 days. This looks to be about 7.5% of their combined debt of $1.6T, which seems an odd calendar concentration. Their recent tendency to go short term (in response to market conditions?) could make rollovers get bigger quite quickly.

Some long overdue poking around in Fannie Mae’s website uncovered their Monthly Summary Archive, which includes their Summary for July 2008. According to Table 7 of this summary, FNM has slightly under $273-billion in money market issuance outstanding and $573-billion in bonds, for a total of $846-billion. The ratio of Money-Market to Bonds outstanding has increased from 1:3.7 in July 2007 to 1:2.0 in July 2008, which is kind of interesting. It might be analytically important; it might be a cause for concern; it might not be. It is certainly something that should be understood before plunking money down on the table, however!

Anyway, if we say that one-quarter of the MM paper outstanding needs to be rolled every month (which assumes an average 4-month initial term; I have no idea how accurate this assumption might be), we arrive at required gross issuance of $68-billion monthly in MM paper simply to refinance the programme.

Bond issuance has totalled $190-billion year-to-date (compared to $194-billion for all of 2007!). If we assume that the YTD rate is representative, this comes to monthly gross issuance of $16-billion bonds.

The total comes to $84-billion to be financed monthly, which makes the figure of $120-billion in the five weeks to September 30 that I passed on in the August 25 report look at least halfway credible.

This level of dependence upon the wholesale market has been blamed for (among other things) the Northern Rock debacle; the Economist has dealt with the subject:

Start with liquidity, the obvious gap in the regulatory firewall. Liquidity risk is barely mentioned in the Basel 2 accord, largely because capital and liquidity were seen as separate (if entwined). The Basel rulemakers are due to issue an updated set of liquidity standards later this year, but devising a sensible regime is no easy task. “Liquidity risk is a kind of catastrophic risk—you either have it or you don’t,” says a senior regulator.

Authoritative references to the Northern Rock fiasco may be found in my post Earth to Regulators: Keep Out!.

Now, I don’t want anybody running out and shorting Fannie Mae because I’ve pointed out that they have an awful lot of short term financing to roll! I will simply point out that a rational investor will understand the nature and vulnerability of their funding mismatch – if any – prior to plunking money down on the table. I will stress yet again that I do not have a view on the investment merits of Fannie Mae preferreds; I’m simply pointing out the various considerations that never make it into the press due to the number of syllables in the words required to explain them.

Scared enough yet? Bloomberg reported a Moody’s press release on prime-Jumbo loans, inter alia:

The performance of mortgage pools in Jumbo transactions from 2006 and 2007 has also weakened relative to that of prior years. While the absolute level of delinquencies remains low in comparison to other RMBS segments, Jumbo delinquencies are building more quickly in recent months.

Moody’s had previously identified some recent-vintage Jumbo transactions that were at risk of downgrade based upon the performance data available at the beginning of 2008. Given the continued performance deterioration in the Jumbo sector, Moody’s is currently reviewing all Jumbo transactions that were originated in 2006 and 2007 .

Second lien pools, a much smaller proportion of RMBS issuance in comparison to first liens, have also experienced extreme poor performance. Moody’s expects 2005 vintage subprime closed-end second (CES) pools to lose 17% on average, 2006 vintage pools to lose 42% on average, and 2007 pools to lose 45% on average. However, given the wide range of deal characteristics and pool performance among transactions, Moody’s expectations for any given transactions can vary significantly.

Prime CES pools have experienced far lower losses than have subprime ones, although, like in every other RMBS sector, 2006 and 2007 vintage delinquencies and losses have been increasing. On average, Moody’s expects 2005 vintage prime CES pools to lose about 6% of their original balance, 2006 vintage pools to lose about 13%, and 2007 vintage pools to lose about 17%.

The performance of recent vintages of home equity line of credit (HELOC) pools has also weakened significantly. Moody’s projects that pool losses on 2005 vintage HELOC transactions will average about 9%, while 2006 vintage transactions will on average lose around 24% and 2007 vintage around 26%.

PerpetualDiscounts were off a bit today, with reasonable volume but a much higher than usual number of big blocks. The average YTW is 6.13%, equivalent to 8.58% interest at the standard conversion factor of 1.4x. Given that long corporates yield about 6.18%, this represents a spread of 240bp; still quite high by historical standards.

There were twenty-three other index-included $25-pv-equivalent issues trading over 10,000 shares today.

The Fannie & Freddie reporters highlighted what they believe to be startlingly new information today – sub-debt does not default with deferred dividends:

Buyers of credit-default swap contracts that protect against losses on Fannie Mae or Freddie Mac subordinated debt may not get paid immediately if the mortgage-finance companies were to defer interest payments as part of a government bailout, according to Bank of America Corp.

While a failure to make the payments permits credit-default swap buyers to cash in on their protection, Freddie and Fannie subordinated bond indentures allow interest to be deferred for as long as five years, or until maturity, if capital cushions breach certain thresholds, Bank of America strategist Glen Taksler in New York wrote in a note to clients yesterday.

Bank sub-debt has been discussed on PrefBlog before, as have Credit Default Swaps. The place of sub-debt in a bank’s capital structure has been mentioned in a review article.

But Citigroup says ‘calm down, people!’:

Fannie Mae and Freddie Mac can withstand losses through the end of the year and still keep a cushion above their minimum capital requirements, according to Citigroup Inc. analysts.

Freddie of McLean, Virginia, will have $12.7 billion of capital above the minimum requirement, according to slides provided by Citigroup for a conference call with investors. Washington-based Fannie will have $20.3 billion.
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The bank’s interest rate strategists led by Scott Peng in New York said last week that the beleaguered mortgage-finance companies don’t need to be nationalized and the U.S. should resist being “stampeded” into a bailout.

Speaking of Fannie, I am thrilled to announce that I have finally seen a definition of “wiped out”, as used in the phrase “Fannie Mae preferred shareholders may get wiped out!!!!!”. According to Dealbreaker:

There had been widespread fear that a government rescue of Freddie would wipe out the preferred shareholders, possibly by subordinating them to new government-owned preferred shares.

I fail to see how the simple fact of subordination to another series of prefs can be equated to a “wipe out”. They’re already subordinated to sub-debt and ordinary liabilities. Would the phrase “wipe out” continue to apply if it was simply more sub-debt being loaded on to the balance sheet? As I discussed on August 22, in the absence of (a credible threat of) liquidation or expropriation, any talk of a preferred share wipe-out at Fannie Mae is simply hysterical nonsense.

If you want to say that Fannie Mae will be liquidated with little or no value to the preferred shareholders, that’s one thing to argue. Or Treasury making an offer they can’t refuse with the threat of liquidation, that’s another. Or Treasury simply expropriating the preferred shares, that’s a third avenue of argument. But simple, straightforward subordination is not equivalent to wipe-out unless one of those arguments holds.

Freddie was downgraded by S&P today:

Standard & Poor’s Ratings Services said today that it affirmed its ‘AAA/A-1+’ senior unsecured debt rating on Freddie Mac with a stable outlook. At the same time, we lowered the risk-to-the-government stand-alone issuer credit rating to ‘A-‘ from ‘A’, the subordinated debt rating to ‘BBB+’, and the preferred stock rating to ‘BBB-‘ from ‘A-‘. The ratings that were lowered are all placed on CreditWatch Negative.
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It could be straightforward funding support through expansion of the Treasury line, buying Freddie Mac’s debt or its agency mortgage-backed securities, or it could consider an equity investment. The possibility of an equity investment is driving Freddie Mac’s equity price lower and the yield on its preferred stock higher. An equity investment by
Treasury could be accompanied by the consideration of nonpayment of existing preferred stock and common dividends.

The subordinated notes pose incremental risk to investors because of an interest deferral feature given certain trigger events tied to Freddie Mac’s regulatory capital levels. The subordinated debt covenant language also states that a deferral of the subordinated debt interest payment triggers the nonpayment of all preferred stock and common dividends, arguing for a close alignment of preferred stock and subordinated debt ratings. However, we now rate the preferred stock two notches below the subordinated debt to reflect the increased risk of nonpayment of dividends as a means of capital preservation. Furthermore, there are no covenants restricting the payment of interest on the subordinated debentures, while the preferred dividends are suspended.

The language is fairly similar in the release announcing the downgrade of Fannie Mae. I must say, a downgrade from A- to BBB- for the preferred stock given the potential for a suspension of the preferred dividend seems to me to be a far more appropriate response than hysterical screaming about wipe-outs.

But!

Wait a minute!

I just remembered!

S&P, in its role as Evil Credit Rating Agency, is paid by the issuer! Geez, that sounds terrible.

And there’s a somewhat related story that Lehman is trying to sell or spin-out-for-cash its Commercial Mortgage assets.

Accrued Interest has engaged in some blue-sky thinking about the GSEs; there’s much with which I disagree:

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.

I don’t think there will be any interim step; I think such action would be economically and idealogically indefensible.

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.

Well … yes there is. The fee can become larger. And structural reforms in US mortgages are urgently needed:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible

But Accrued Interest‘s main suggestion is:

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?
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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.

It’s a very interesting idea … I’ll have to think about it a bit more. My first thought is that covered bonds are generally AAA anyway – how much could the GSEs charge for adding another layer of protection?

Covered bonds have been recently approved by the FDIC and were discussed on PrefBlog last fall.

When reviewing the 3Q08 BMO Financials, I noted that they were keeping assets constant while beefing up their capital – thus engaging in some gentle delevering. Bank borrowing is getting expensive:

Banks, securities firms and lenders have a record $871 billion of bonds maturing through 2009, according to JPMorgan Chase & Co., just as yields are at their most punitive compared with Treasuries. The increase in yields may cost them as much as $23 billion more in annual interest versus a year ago based on Merrill Lynch index data.

Higher refinancing expenses will restrict the ability of banks to borrow in the capital markets and lend, further cutting off credit to consumers and businesses and curbing what is already the slowest growing economy since 2001. Standard & Poor’s said last week that it had a “negative” outlook on almost half of the 50 highest-rated financial institutions in the U.S. as of June 30, the highest proportion in 15 years.

PerpetualDiscounts eased off a bit today, on reasonably average volume. What should I say? According to “Investment Punditry for Dummies”, I could say “profit taking”, “concern about this week’s bank earnings announcements”, “making room for a new BNS issue” … there’s lots of choices! I think I’ll just say “I have no idea. Ask a priest!” and leave it at that.

There were twenty-three other index-included $25-pv-equivalent issues trading over 10,000 shares today.