August 26, 2008

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.


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.

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
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 4.61% 4.36% 57,351 16.42 7 +0.0643% 1,111.4
Floater 4.06% 4.10% 42,481 17.15 3 -0.5301% 909.6
Op. Retract 4.96% 4.02% 110,410 2.54 17 +0.2351% 1,054.2
Split-Share 5.35% 5.93% 54,295 4.42 14 +0.0413% 1,040.3
Interest Bearing 6.25% 6.76% 46,703 5.22 2 -0.5059% 1,120.6
Perpetual-Premium 6.15% 6.02% 64,903 2.22 1 +0.3953% 993.6
Perpetual-Discount 6.06% 6.12% 189,615 13.54 70 -0.0676% 878.5
Major Price Changes
Issue Index Change Notes
POW.PR.D PerpetualDiscount -1.9404% Now with a pre-tax bid-YTW of 6.13% based on a bid of 20.72 and a limitMaturity.
SLF.PR.E PerpetualDiscount -1.8858% Now with a pre-tax bid-YTW of 6.18% based on a bid of 18.21 and a limitMaturity.
BAM.PR.B Floater -1.4948%  
FBS.PR.B SplitShare -1.0246% Asset coverage of just under 1.5:1 as of August 21, according to TD Securities. Now with a pre-tax bid-YTW of 6.26% based on a bid of 9.66 and a hardMaturity 2011-12-15 at 10.00.
CM.PR.G PerpetualDiscount -1.0140% Now with a pre-tax bid-YTW of 6.68% based on a bid of 20.50 and a limitMaturity.
BAM.PR.I OpRet +2.6348% Now with a pre-tax bid-YTW of 5.44% based on a bid of 25.32 and a softMaturity 2013-12-30 at 25.00. Compare with BAM.PR.H (6.08% to 2012-3-30), BAM.PR.J (6.41% to 2018-3-30) and BAM.PR.O (7.37% to 2013-6-30).
Volume Highlights
Issue Index Volume Notes
SLF.PR.C PerpetualDiscount 108,100 CIBC crossed 105,000 at 18.31. Now with a pre-tax bid-YTW of 6.08% based on a bid of 18.31 and a limitMaturity.
CM.PR.R OpRet 83,450 TD crossed 25,000 at 25.80, then another 25,000 at 25.90. CIBC crossed 25,000 at 25.80. Now with a pre-tax bid-YTW of 4.57% based on a bid of 25.65 and a softMaturity 2013-4-29 at 25.00.
ENB.PR.A PerpetualDiscount 42,050 CIBC crossed 38,700 at 23.60. Now with a pre-tax bid-YTW of 5.85% based on a bid of 23.59 and a limitMaturity.
SLF.PR.B PerpetualDiscount 41,835 Desjardins crossed 25,000 at 19.71. Now with a pre-tax bid-YTW of 6.10% based on a bid of 19.70 and a limitMaturity.
TD.PR.O PerpetualDiscount 37,975 Desjardins crossed 25,000 at 21.05. Now with a pre-tax bid-YTW of 5.80% based on a bid of 21.14 and a limitMaturity.

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

3 Responses to “August 26, 2008”

  1. prefhound says:

    Re Fannie and Freddie, I enjoy your coverage. I am more worried about a failed debt auction than where book equity should be at the end of the year if business can continue “as usual”.

    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.

    On the plus side, the June 30 financials show $370B of cash on the combined balance sheets. It would be interesting to know how this compares with the debt repayment schedules and how much (if any) came from the Fed. Meanwhile, cash = 10X equity!

    Also on the very slightly plus side, the GSEs have greatly increased their fees — although this doesn’t start until Oct 1 and won’t affect existing contracts.

    With normal companies it is absence of cash, not negative book equity, that determines when bankruptcy protection is needed. In this case, regulations on book equity may kick in sooner, but politicians have demonstrated a recurrent ability to rewrite those at will (which is part of the problem).

    Finally, at Fannie Mae, prefs are about 3% of debt, and consume less than $1B in dividends per year (against $40B of interest), so the economic value of/need to eliminate pref dividends won’t make much real difference to operations –especially since common dividends have been nearly eliminated. Whatever happens to pref shares will be for optics rather than economics.

    On balance, the GSEs should have until the end of the year, but in an election year, politicians may not have quite so much time.

  2. jiHymas says:

    Glad you like the coverage!

    I agree with you that the major source of worry is a failed debt auction; or, possibly, a successful auction in which the stop-out yield is so high as to make the business completely uneconomic.

    Either of those events would trigger a Treasury move, I think.

    It’s a tricksy thing to analyze, because so much of it depends on the momentum of the credit markets. Arguments will continue forever regarding whether Bear Stearns should have failed or not; but the fact is that they were in a position where they were susceptible to rumour. That was enough for them; it might be enough for Fannie.

    I confess that my figure of $120-billion impending rollover is strictly a copy-paste from Bloomberg – I have not verified it myself.

  3. […] 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.…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. […]

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