PrefBlog

James Hamilton of Econbrowser asks Did Fannie and Freddie Cause the Mortgage Crisis, reviewing an op-ed piece by Paul Krugman. Krugman states of the implicit guarantee of the GSE debt:

This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.

This is certainly true to some extent, but more analysis is needed. What have Fannie & Freddie’s Return on Equity been, relative to “real banks”? To the extent that this ROE has exceeded the ROE on real banks, the profits have been privatized to the benefit of the common equity holders. And, importantly, to the extent that mortgage rates have been reduced – and all the other bells and whistles (reviewed on May 7, referencing Crony Capitalism) thrown in – the profits have been privatized to the benefit of the mortgage-borrowing public.

The distinction is important if for no other reason than, for better or worse, privatizing the profits to the mortgage-borrowing public was precisely the public policy purpose behind the GSE legislation. Which is not to say I agree with this purpose, mind you, but if we’re going to identify villains, let’s at least identify them correctly.

As pointed out Calculated Risk and by Michael Carliner, a large portion of the blame for excessively loose lending can be ascribed to a fight for market share between the GSEs and private lenders.

This, to me, looks like a natural consequence of reducing the risk premium on qualifying mortgages. There will always be investors who wish to outperform by taking risks – this may be a well-thought out strategy, or … er … otherwise. The risk premium on GSE mortgage-backeds has been much smaller than it should be:

“If the agencies’ debt and mortgage-backed securities (MBS) were priced based on their stand-alone financials, the paper would pay more than 100bp, rather than around 20bp over Treasuries,” [UC Berkeley finance professer Dwight] Jaffee says. So Fannie and Freddie have access to a more favourable funding on the back of a de facto credit guarantee.

Mind you, “risk premium” is an imprecise term. Credit risk? Liquidity risk? Prepayment risk? Ignoring such bond-geek adjustments, there is widespread agreement that agency MBS traded to yield a lot less than they would have had they been issued by normal corporations – but that was the whole point of the GSEs in the first place.

The miniscule risk premia available in normal corporate debt in the early part of this decade created an appetite for higher risk debt. The artificial lowering of the risk premia on agency MBS was a large factor in guiding this appetite towards riskier mortgages.

For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?

Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer– private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

Is that the answer to the second question? I’m not sure. But if anybody has a better answer, I’d still like to hear it.

Well, I can’t answer the first question! I’ll just rather pedantically point out that there is an implicit assumption that 1980 was “right” and 2003 was “wrong” … probably a pretty safe assumption, but an assumption nevertheless. Either way, it can be fairly safely ascribed to the deliberate policy decision taken by the US Govt. when creating the GSEs – guarantee or no guarantee, they are subject to much less stringent capital rules than are commercial banks. At the very least, the ability to offer a steady series of MBS in size will reduce the liquidity premium on their issues.

Prof. Hamilton’s suggested answer to his second question strikes me as too clever. I will simply suggest that subPrime paper should – after structuring – trade at a reasonable spread to prime paper. When the risk premia on prime paper is artificially reduced, the premia on sub-prime paper will be reduced likewise – despite the fact that the sub-prime paper has no guarantee, implicit or explicit. And when there is sufficient demand for spread paper … it gets met!

Wells Fargo reported non-apocalyptic earnings, sparking a huge rally in US Financials:

U.S. stocks rallied after higher- than-estimated profit at Wells Fargo & Co. sparked the biggest- ever gain in financial shares and a two-day tumble in oil prices brightened the outlook for transportation companies.

Wells Fargo, which avoided the worst of the fallout from the subprime mortgage market’s collapse, jumped the most since at least 1980, leading Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. higher.

Accrued Interest ascribes the move to short covering:

CDS on WFC fell 25bps, with other banks 10ish tighter.

Now this is mostly short-covering, I’m sure. You have Wells Fargo, the most staid bank in the country, rallying 30% in a single day. Only panicky shorts can cause such a sudden shift in a name like Wells. Hell, the whole S&P Financials sector is up over 10%.
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This bear market isn’t going to end with investors suddenly having confidence in financials. It will end when shorting financials doesn’t seem like an easy trade any more.
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Anyway, we’ll see how J.P. Morgan and Merrill Lynch come out tomorrow. I expect a good market reaction either way after J.P Morgan’s numbers. Merrill is more risky. Continue to be short duration.

Merrill has some juicy assets on the block – Bloomberg and Blackrock.

Short duration? One rationale is a US refunding crisis. Naked Capitalism passes on some apocalyptic clippings.

Well, volume picked up a bit, there were some crosses put on the board … and the PerpetualDiscount index continued its plunge. I saw some activity that looked like bottom fishing … but I’m ALWAYS going to see activity that looks like bottom-fishing. You figure it out!

PerpetualDiscounts now have an average yield of 6.63%, which is 9.28% interest-equivalent at the standard 1.4x conversion factor. Since long corporates still haven’t noticed the world is about to end and continue to yield about 6.1%, this makes the spread 318bp.

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

The concept of credit protection on the United States of America has captured imaginations all around, with Accrued Interest referring to it as a “chaos trade” – defining this as “positions designed to produce big returns if all hell breaks loose” and Naked Capitalism comparing US Treasuries to senior debt of the GSEs. Certainly the greenback continues to sink against the Euro.

Equities did very poorly today, with General Motors suspending its dividend.

Cheyne Finance, last mentioned on October 22 and November 13, is having a $6-billion fire sale:

The first auction of assets by a structured investment vehicle drove Moody’s Investors Service to downgrade the Cheyne Finance Plc SIV by five levels, describing it as a “fire sale.”

The $6 billion SIV set up by London-based Cheyne Capital Management (UK) LLP is scheduled to auction its assets this week or transfer them to a new company under a reorganization by receivers Deloitte & Touche LLP and Goldman Sachs Group Inc. Moody’s said it cut the SIV’s senior debt to Ca, its second- lowest grade, in a report today.

And Willem Buiter fulminates on the real meaning of the GSE bailout:

The Treasury has taken another big step on the road to Utter Fiscal Obfuscation. It is doing everything it can to disguise the fact that it is entering in commitments that create potentially massive contingent liabilities for the US tax payer. Even if the purpose served by this increase in contingent liabilities is worth the cost, the manner in which it is done is designed to avoid fiscal accountability. This is as welcome to the Executive as it is to the Congress.

Note to all aspiring politicians: guarantees are not a cost-free method of accomplishing social goals. They will be called in at the most inopportune time.

Here’s an interesting factoid:

The S&P 500 Financials Index dropped 3 percent, capping its steepest-ever five-day retreat and giving the industry a smaller market value than health care for the first time since 1992, S&P data show.

Amidst all this gloom, I will remind readers that Bombardier first halved, then suspended its common dividend a few years back – the common dividend has only recently been reinstated. But the preferreds kept on paying through the period. First loss protection is not just a theoretical construct!

What a life! If anything, the panic is spreading … the price-movers list is longer today than it was, there were a number of block trades in the volume highlights and the PerpetualDiscount index was down more than a point for the second day running, to yield 6.58% … 9.21% interest-equivalent, long corporates +311bp. On the other hand, a few CM issues were up significantly on the day … which could imply the emergence of bottom fishers, it could be a dead-cat bounce, or it might mean absolutely nothing at all. I’ll let you know when it’s all over.

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

The implicit guarantee of the GSE will – probably – shortly become explicit.

James Hamilton of Econbrowser reviews the situation and approves of the plan:

The first thing I like about this plan is the fact that the ultimate determination of the level of risks to be absorbed by the federal government is being left to Congress.
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The second thing I like about the plan is that such action by Congress would take the form of a dollar limit– here’s how much we’re willing to stake, and no more– with residual losses presumably laid on the GSE creditors.

Accrued Interest mourns bad decisions of the past:

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.

The WSJ Economics Blog collected some opinion from Street economists – mostly neutral and a bit bewildered, but with one interesting observation that it made shorting the stock a riskier proposition than otherwise. Jim Rogers and George Soros hate it. Naked Capitalism supplies further clippings.

From the Interesting Factoid department comes an estimate of Canadian banks’ exposure to the US:

BMO had the highest loan exposure at $51 billion, while TD’s exposure was estimated to be $46 billion. The two Canadian banks have focused their U.S. banking businesses on different regions – Chicago and the Midwest in the case of Bank of Montreal and the U.S. Northeast in the case of Toronto-Dominion.

Commercial loans to real estate and financial services companies made up about 43 per cent of the total amount at both banks.

[Blackmont Capital analyst Brad] Smith also noted that Royal Bank (TSX: RY.TO) only had a “modest exposure” worth $25 billion or 10 per cent of the outstanding loans, “surprisingly, given its well-established U.S. retail banking and global capital markets business.”

The least at risk were CIBC (TSX: CM.TO) and Scotiabank (TSX: BNS.TO), both with single-digit exposure.

He concludes … :

[TD & BMO] could see their earnings per share decline as much as seven per cent next year

Wow, earnings down as much as 7%, eh? Holy smokes! There’s a little perspective for you! Stockbrokers, I’m sorry to say, are busily attempting to convince clients that preferred dividends from banks in Canada are at risk. I’ll start paying attention when I hear a little less “could” and “might” and a few more numbers.

This market is getting surreal. PerpetualDiscounts are now yielding 6.49%, equivalent to 9.09% interest at a conversion factor of 1.4x. Long corporates continue to yield 6.1%, so the Pre-tax Interest-Equivalent spread is now just a hair under 300bp.

In the volume leaders, only two blocks were traded – both by CIBC and both 60,000 shares, so there’s even a possibility they’re related.

If I was seeing any confirmation in the bond market that the world was about to end, I’d be taking this a lot more seriously. I wouldn’t necessarily agree with the bond market’s analysis, understand, but I would have to consider predictions of impending doom with a sharper eye to detail. But we’re not seeing any of that. Volume is light and there are incredible moves happening on featherweights! PerpetualDiscounts were down over 1% today! That’s a bad MONTH!

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