How much Government Sponsored Enterprise debt do Australian banks own? We began our day with this question and did not get very far in answering it. But the answer would be worth knowing. Why?
There are two major Government Sponsored Enterprises (GSE) in the U.S. They go by the name of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). Their job is to purchase mortgages in the ‘secondary market’ and thereby provide liquidity to the U.S. housing market. They basically buy the mortgages originated by other lenders. They do this by issuing bonds which until recently they could do at a lower-than-normal interest rate because of the implied government guarantee the GSEs enjoy. You sell short-term debt to lend long. Ugh.
Monday, FRE shares fell 18% and FNM shares fell 16%. Both firms face two big problem. The first is that continued write downs in the housing market force them to raise capital, diluting existing shareholders. Shareholders are already down 60% on each firm in the last year. Many shareholders realise that the GSEs may need so much capital, that the existing shares are going to be diluted into oblivion. It’s a good reason to sell, unless you are oblivious.
The second big problem is an accounting rule called FAS 140 which requires financial firms to move off-balance sheet vehicles back on the balance sheet. Companies prefer to keep off-balance sheet vehicles off the balance sheet because the assets in those vehicles suck, or, more precisely, are either hard to value or must be valued at the current market. If you have a crazy Aunt, you’d prefer to keep her in the attic where she won’t embarrass you in front of the neighbours.
But the neighbours have begun to notice anyway. A report issued by a Lehman Brother’s analyst yesterday concluded that if Fannie and Freddie had to comply with FAS 140, it would force them raise as much as US$75 billion in capital. The Lehman analyst then correctly pointed out that such an expensive application of the rule would probably never happen. The government would simply exempt the GSEs from complying. If you haven’t noticed, it’s pretty tough to raise US$75 billion these days.
But the GSEs may have to raise capital anyway. Investors sold off their bonds yesterday because they are growing convinced the guarantees slapped on the bonds by the Government Sponsored Enterprises or the bond insurers are not worth the paper they are written on. You can measure this by the “spread” between the yield on GSE bonds and Treasury bonds. It’s blowing out like it did last year.
According to FTN Financial, “Bonds backed by home loans guaranteed by Fannie Mae Monday afternoon were yielding around 2.4 percentage points over Treasury securities, up from 2.33 percentage points at the end of last week and 1.9 percentage points six weeks ago. At the height of the credit crisis in mid-March, that ‘spread’ jumped to 2.9 percentage points.”
When yields rise and prices fall, it generally means bond investors want to be compensated for the increased risk of owning bonds. Hey, maybe risk is actually back in the markets. If Risk really is back (and angry) this presents a host of problems for investors and the GSEs. For the GSEs, they now have to pay more to borrow. They’ll borrow less.
For would-be homeowners, that means the GSEs will be retrenching their activity in the mortgage market at just the moment they are supposed to be the key liquidity providers. Less housing credit available means more falling home prices in the U.S. Ouch.
But there might be a nasty surprise for investors who think U.S. Treasury bonds and notes are really safe. The market for tradeable U.S. Treasury bonds and notes is around US$4.5 trillion. Because of the housing bubble from 2003 to 2007, Government Sponsored Enterprise debt outstanding is even larger at US$5.2 trillion. Who bought that debt?
Everybody did! You may even own some of it without knowing it.
Foreign central banks, pension funds, hedge funds, you name it…GSE debt was more liquid than Treasuries. It also had a higher yield than U.S. government debt, but enjoyed the implied (although not stated) guarantee of the U.S. Treasury Department. More yield, same safety. Investors think if push comes to shove, the U.S. government will honour the obligations issued by the GSEs.
From a first glance, it doesn’t look like the Australian banks we looked at this morning have a ton of GSE debt on the books that they might want to sell or might have to mark down. We’re sure it’s lurking somewhere. We just haven’t found it. But aside from the bondholders, there’s a bigger story here.
Do you see who really owns the risk on Government Sponsored Enterprise bonds? The bondholders, for one. They will probably be paid in inflated dollars. The American taxpayer is next in line. The inflation required to pay GSE bondholders will come straight out of his purchasing power, which is not doing so hot to begin with.
But if the U.S. Government chooses to bail out the Government Sponsored Enterprises, what do you think it will do for the value of the U.S. dollar? Taking on the GSEs massive liabilities and dubious assets is a gargantuan financial task even for the U.S. Government, used to gargantuan financial mismanagement. It is a whole bottle of poison pills, swallowed in one big gulp.
We believe investors seeking safety in the U.S. Treasury market are misunderstanding the fundamental risk of a crisis in the GSEs. That real casualty of a GSE meltdown is the global dollar standard itself, which is already under a lot of strain.
A Government Sponsored Enterprise nationalisation would cause the dollar to buckle under the weight of additional dollar denominated obligations for a government that already has many more than it can realistically pay. Bond yields on American government debt would rise and prices would plummet. The U.S. economy would be plunged into a truly terrible reckoning for its credit excesses.
So are we witnessing the opening lines of the final act of the dollar crisis? And if so, what does it mean for resource prices?
Markets and Money