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%.

…

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.…

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.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30 |
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Index | Mean Current Yield (at bid) | Mean YTW | Mean Average Trading Value | Mean Mod Dur (YTW) | Issues | Day’s Perf. | Index Value |

Ratchet | 4.32% | 3.94% | 41,130 | 0.08 | 1 | +0.000% | 1,122.4 |

Fixed-Floater | 4.66% | 4.39% | 70,609 | 16.34 | 6 | +0.0429% | 1,088.3 |

Floater | 4.13% | 4.15% | 50,865 | 17.11 | 3 | -0.1647% | 892.4 |

Op. Retract | 4.99% | 4.62% | 152,371 | 3.09 | 17 | -0.1841% | 1,040.5 |

Split-Share | 5.47% | 6.81% | 64,147 | 4.08 | 14 | -0.2041% | 1,010.7 |

Interest Bearing | 6.15% | 5.38% | 42,742 | 1.96 | 3 | +0.0347% | 1,120.2 |

Perpetual-Premium | 6.16% | 6.05% | 67,755 | 10.62 | 4 | -0.4961% | 978.9 |

Perpetual-Discount | 6.56% | 6.63% | 237,266 | 13.05 | 67 | -0.6605% | 806.3 |

Major Price Changes |
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Issue | Index | Change | Notes |

CM.PR.D | PerpetualDiscount | -4.6680% | Now with a pre-tax bid-YTW of 7.30% based on a bid of 19.81 and a limitMaturity. |

POW.PR.C | PerpetualDiscount | -4.6258% | Now with a pre-tax bid-YTW of 6.96% based on a bid of 21.03 and a limitMaturity. |

ELF.PR.F | PerpetualDiscount | -3.6545% | Now with a pre-tax bid-YTW of 7.68% based on a bid of 17.40 and a limitMaturity. |

POW.PR.D | PerpetualDiscount | -3.2105% | Now with a pre-tax bid-YTW of 6.86% based on a bid of 18.39 and a limitMaturity. |

CM.PR.G | PerpetualDiscount | -3.1053% | Now with a pre-tax bid-YTW of 7.38% based on a bid of 18.41 and a limitMaturity. |

RY.PR.W | PerpetualDiscount | -3.0485% | Now with a pre-tax bid-YTW of 6.44% based on a bid of 19.40 and a limitMaturity. |

BNA.PR.C | SplitShare | -2.9650% | Asset coverage of 3.2+:1 as of June 30, according to the company. Now with a pre-tax bid-YTW of 8.56% based on a bid of 18.00 and a softMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (6.21% to 2010-9-30) and BNA.PR.B (8.50% to 2016-3-25). One can also compare with the March 12 close, when BNA.PR.B was yield 128bp over BNA.PR.C. The price spread (bid/bid) is now $2.27, which may be compared with prefhound‘s March 12 estimate of $2. |

ELF.PR.G | PerpetualDiscount | -2.8571% | Now with a pre-tax bid-YTW of 7.83% based on a bid of 15.30 and a limitMaturity. |

IAG.PR.A | PerpetualDiscount | -2.5700% | Now with a pre-tax bid-YTW of 6.82% based on a bid of 17.06 and a limitMaturity. |

PWF.PR.D | OpRet | -2.2308% | Now with a pre-tax bid-YTW of 6.41% based on a bid of 25.42 and a softMaturity 2012-10-30 at 25.00. |

POW.PR.A | PerpetualDiscount | -2.1739% | Now with a pre-tax bid-YTW of 6.97% based on a bid of 20.25 and a limitMaturity. |

CM.PR.I | PerpetualDiscount | -2.1354% | Now with a pre-tax bid-YTW of 7.37% based on a bid of 16.04 and a limitMaturity. |

BNS.PR.K | PerpetualDiscount | -2.0439% | Now with a pre-tax bid-YTW of 6.29% based on a bid of 19.17 and a limitMaturity. |

DFN.PR.A | SplitShare | -2.0222% | Asset coverage of 2.3+:1 as of June 30 according to the company. Now with a pre-tax bid-YTW of 5.92% based on a bid of 9.69 and a hardMaturity 2014-12-1 at 10.00. |

BNS.PR.O | PerpetualDiscount | -1.9264% | Now with a pre-tax bid-YTW of 6.14% based on a bid of 22.91 and a limitMaturity. |

TCA.PR.Y | PerpetualDiscount | -1.8974% | Now with a pre-tax bid-YTW of 5.92% based on a bid of 47.05 and a limitMaturity. |

PWF.PR.G | PerpetualDiscount | -1.8684% | Now with a pre-tax bid-YTW of 6.40% based on a bid of 23.11 and a limitMaturity. |

BAM.PR.H | OpRet | -1.8000% | Now with a pre-tax bid-YTW of 6.43% based on a bid of 24.55 and a softMaturity 2012-3-30 at 25.00. Compare with BAM.PR.I (6.03% to 2013-12-30), BAM.PR.J (7.07% to 2018-3-30) and BAM.PR.O (6.45% to 2013-6-30). |

GWO.PR.G | PerpetualDiscount | -1.7885% | Now with a pre-tax bid-YTW of 6.84% based on a bid of 19.22 and a limitMaturity. |

BMO.PR.K | PerpetualDiscount | -1.6787% | Now with a pre-tax bid-YTW of 6.52% based on a bid of 20.50 and a limitMaturity. |

DF.PR.A | SplitShare | -1.6310% | Asset coverage of just under 2.0:1 as of June 30 according to the company. Now with a pre-tax bid-YTW of 6.00% based on a bid of 9.65 and a hardMaturity 2014-12-1 at 10.00. |

ELF.PR.G | PerpetualDiscount | -1.8080% | Now with a pre-tax bid-YTW of 7.61% based on a bid of 15.75 and a limitMaturity. |

RY.PR.H | PerpetualDiscount | -1.5665% | Now with a pre-tax bid-YTW of 6.21% based on a bid of 23.25 and a limitMaturity. |

CM.PR.J | PerpetualDiscount | -1.5152% | Now with a pre-tax bid-YTW of 7.26% based on a bid of 15.60 and a limitMaturity. |

CU.PR.A | PerpetualDiscount | -1.3848% | Now with a pre-tax bid-YTW of 6.26% based on a bid of 23.50 and a limitMaturity. |

CM.PR.E | PerpetualDiscount | -1.2632% | Now with a pre-tax bid-YTW of 7.51% based on a bid of 18.76 and a limitMaturity. |

BMO.PR.L | PerpetualDiscount | -1.2609% | Now with a pre-tax bid-YTW of 6.57% based on a bid of 22.71 and a limitMaturity. |

PWF.PR.F | PerpetualDiscount | -1.2358% | Now with a pre-tax bid-YTW of 6.88% based on a bid of 19.18 and a limitMaturity. |

NA.PR.M | PerpetualDiscount | -1.2058% | Now with a pre-tax bid-YTW of 6.31% based on a bid of 23.76 and a limitMaturity. |

BNS.PR.J | PerpetualDiscount | -1.1765% | Now with a pre-tax bid-YTW of 6.28% based on a bid of 21.00 and a limitMaturity. |

IGM.PR.A | OpRet | -1.1446% | Now with a pre-tax bid-YTW of 5.01% based on a bid of 25.91 and a limitMaturity. |

PWF.PR.K | PerpetualDiscount | -1.1105% | Now with a pre-tax bid-YTW of 6.65% based on a bid of 18.70 and a limitMaturity. |

PWF.PR.I | PerpetualDiscount | -1.0526% | Now with a pre-tax bid-YTW of 6.40% based on a bid of 23.50 and a limitMaturity. |

ENB.PR.A | PerpetualDiscount | +1.0231% | Now with a pre-tax bid-YTW of 6.14% based on a bid of 22.71 and a limitMaturity. |

SLF.PR.C | PerpetualDiscount | -1.1976% | Now with a pre-tax bid-YTW of 6.14% based on a bid of 22.71 and a limitMaturity. |

BAM.PR.I | OpRet | +1.2397% | Now with a pre-tax bid-YTW of 6.03% based on a bid of 24.50 and a softMaturity 2013-12-30. Compare with BAM.PR.H, above. |

RY.PR.A | PerpetualDiscount | +1.2936% | Now with a pre-tax bid-YTW of 6.29% based on a bid of 18.01 and a limitMaturity. |

MFC.PR.C | PerpetualDiscount | +1.8130% | Now with a pre-tax bid-YTW of 6.34% based on a bid of 17.97 and a limitMaturity. |

LFE.PR.A | SplitShare | +1.8237% | Asset coverage of just under 2.2:1 as of June 30, according to the company. Now with a pre-tax bid-YTW of 5.20% based on a bid of 10.05 and a hardMaturity 2012-12-1 at 10.00. |

PWF.PR.H | PerpetualDiscount | -1.0738% | Now with a pre-tax bid-YTW of 6.52% based on a bid of 22.11 and a limitMaturity. |

SLF.PR.E | PerpetualDiscount | +2.6332% | Now with a pre-tax bid-YTW of 6.63% based on a bid of 17.15 and a limitMaturity. |

CIU.PR.A | PerpetualDiscount | +2.6472% | Now with a pre-tax bid-YTW of 6.15% based on a bid of 19.00 and a limitMaturity. |

Volume Highlights |
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Issue | Index | Volume | Notes |

BAM.PR.H | OpRet | 180,813 | There is some difference of opinion regarding the volume on this one! The Financial Post shows Nesbitt crossing: 100,000 at 1:26pm; 80,000 at 1:47pm; 40,000 at 2:30pm; 40,000 at 2:43pm; all at 24.55. The TSX shows total volume as listed and Nesbitt crossing: 100,000 at 1:26pm; 40,000 at 1:47pm; 40,000 at 2:43pm; all at 24.55. Take your pick! See above for price movement. |

TD.PR.O | PerpetualDiscount | 76,200 | Anonymous either crossed, or sold to another anonymous, 50,000 at 20.46. Now with a pre-tax bid-YTW of 6.00% based on a bid of 20.30 and a limitMaturity. |

CM.PR.I | PerpetualDiscount | 35,842 | Now with a pre-tax bid-YTW of 7.37% based on a bid of 16.04 and a limitMaturity. |

BNS.PR.K | PerpetualDiscount | 25,725 | Now with a pre-tax bid-YTW of 6.29% based on a bid of 19.17 and a limitMaturity. |

BMO.PR.L | PerpetualDiscount | 23,725 | RBC crossed 10,800 at 23.00. Now with a pre-tax bid-YTW of 6.57% based on a bid of 22.71 and a limitMaturity. |

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

CM.PR.D leads your hit parade with a drop of 4.7% when the common is up 7.3%?? Go figure..

I’m figuring as fast as I can!

Note, however, that CM.PR.D still yields a little less CM’s other issues: pre-tax yields at bid are:

CM.PR.D, 7.30%

CM.PR.E, 7.51%

CM.PR.G, 7.38%

CM.PR.H, 7.39%

CM.PR.I, 7.37%

CM.PR.J, 7.26%

CM.PR.P, 7.28%

[…] day month-to-date, totalling 1.38%. They have had only one down-day (July 28) since the trough on July 16 and are now up 6.62% since trough-date. Average dividend yield is now 6.23%, equivalent to 8.72% […]