GSE Bailout: Turning Point or Tipping Point?
publication date: Sep 7, 2008
No, it wasn't Bill Gross from PIMCO talking his own book on CNBC and demanding an immediate rescue plan. The sobering truth of the sudden GSE bailout this weekend, after months of prevarication by the Treasury, was that it was forced upon a reluctant US government by the realisation that both Fannie and Freddie had cooked the books by hiding huge off-balance sheet liabilities (and I bet they're not the only ones). As a result, Morgan Stanley concluded in their review of GSE finances on behalf of Hank Paulson that both were dangerously undercapitalised and needed an urgent infusion of cash. The dumping of GSE debt by the Chinese and Russians among others has also hastened this decision. The equity markets may well see a knee-jerk relief rally on this historic intervention, but it will prove short lived I suspect, for several reasons.
1. The accounting practices used and abused by Fannie and Freddie, for instance in treating Level 3 assets, are widely applied across the US financial sector, and imply widespread undercapitalisation (or more bluntly insolvency). These won't be the last institutions 'nationalised' by the US government. Worryingly, leading investment banks like GS and Merrills recently issued bullish notes on the GSEs claiming them to be well capitalized for at least 2009. Not just shameless, but clueless too. $200 oil, anyone?
2. The hoped for upside in a move like this is that the now explicit government guarantee on GSE debt will bring down GSE spreads to closer to their previous norm of around a 125bp premium over Treasuries, down from 250bp plus at present. But what if the opposite happens? What if Treasuries are infected by the GSE virus of financial recklessness and see their perceived risk and yields rise? Instead of a boon for the housing market, this may turn out to be a bust for US deficit financing; taxpayers will have to foot a bill of $100-250bn for delinquencies, depending on just how long the housing bust goes on and how high a default rate prime mortgages suffer; something around half the general level of mortgage deliquency would mean 4.5% of the outstanding GSE loan book of $5.2trn. It sure isn't long bond friendly news, and I'd expect a reversal this week in both recent bond and dollar rallies.
3. Bizarrely, both common and preferred stock will still trade, albeit without a dividend, so we will continue to see wild day trading of these zombie securities. Fannie and Freddie have failed as hybrid private companies, be done with it. The slump in value of the preferred will have a nasty knock-on impact on regional bank holders, and indeed foreign central banks. While the MBS market should rally, the impact on the CDS market is likely to be destabilising upheaval and long-term legal wrangling. I suspect the writeoffs from GSE preferred stock could push the capital adequacy of several small/regional US banks below the waterline and set off a spate of new failures. This event may prove to be be a classic case of being careful what you wish for, and with the risk of deteriorating economic data making a US recession call all but inevitable for investors, the next few weeks promise to be terrifyingly volatile, even by recent extreme standards
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