PrefBlog

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.
…
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.
…
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?
…
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.

Freddie Mac had a gushing review on Bloomberg today:

Freddie Mac rose 17 percent in New York trading after a $2 billion sale of short-term debt stoked confidence the second-largest U.S. mortgage-finance company can still attract investors.
…
Freddie Mac sold $1 billion of three-month notes at a yield of 2.58 percent, the company said today. That translates to about 90 basis points more than similar-maturity U.S. Treasuries and 23 basis points less than the three-month London interbank offered rate. The spreads from last week’s sale were 61 basis points over Treasuries and 32 basis points below Libor, according to Stone & McCarthy Research Associates.

The company also sold $1 billion of six-month debt at a yield of 2.858 percent, a spread of about 92 basis points above Treasuries and 25.5 basis points below Libor; compared with 80 basis points and 32 basis points last week. A basis point is 0.01 percentage point.

Well … it’s nice that they were able to finance through LIBOR, but let’s not get carried away! Let’s see how well they can finance the next month’s needs:

Fannie has about $120 billion of debt maturing through Sept. 30, while Freddie has $103 billion, according to figures provided by the companies and data compiled by Bloomberg.

… on the bond market, rather than the Money-Market, before breaking out the champagne. Unless my trusty calculator has let me down, $2-billion is less than half their daily quota until September 30 … each.

Fortunately for oenophiles, there is an excuse for some bubbly. PerpetualDiscounts were up 21bp today, bringing the total return index back to slightly above its June 30 levels … OK now it’s time to start working on June (a really, really lousy month).

The perpetualDiscount index now has a weighted average mean yield to maturity of 6.11%, equivalent to 8.55% interest at the standard 1.4x equivalency factor. Long corporates now yield in the 6.15-6.20% range, so the pre-tax interest-equivalent spread is now about 235bp.

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

Update: Dealbreaker passes on a rumour that Fed Pressures Treasury Not To Wipe Out Fannie Mae Preferreds:

The Federal Reserve has been quietly pressuring the Treasury Department not to adopt a rescue plan for Fannie Mae and Freddie Mac that would wipe out the value of their preferred shares, according to a source familiar with the matter. The Fed fears that any move that hurt the preferred could worsen the crisis in regional banks that is already under way.
…
The situation is complicated, however, by the large share of preferred stock held by regional banks, many of which are viewed as possible candidates for failure in these credit crunched times. As the Financial Times reported over the weekened regional banks and US insurers hold the majority of Fannie and Freddie’soutstanding preferred stock. The Fed has begun advocating against wiping out these shares, saying the threat to stability of the banks is greater than the ‘moral hazard’ argument, a source familiar with the matter says.

As usual, it’s not clear what is meant by “wiping out”.