Investors in securities backed by Fannie Mae and Freddie Mac are locked in a test of wills with the US Treasury.
The interim rescue plan for the two US government-sponsored mortgage financiers has come under severe market strain in recent weeks. Prices for Fannie and Freddie’s debt and equity securities have delivered conflicting signals about investor confidence in the US Treasury’s commitment to an intervention for the two beleaguered mortgage companies.
The reasoning behind the rescue plan unveiled on July 13 was that investors would be reassured by the Treasury obtaining authority to invest in Fannie and Freddie, thereby reducing the likelihood that the government would actually have to bail them out. Instead, equity investors are betting on the near certainty of a bail-out, while debt investors appear far from reassured.
“Significant declines in the prices of Fannie and Freddie securities recently reflect the market testing the Treasury department’s resolve to utilise its newly granted powers,” said Ira Jersey, interest rate strategist at Credit Suisse.
Shares in both government-sponsored enterprises plunged this week after a report in Barron’s magazine said the Treasury would inject capital in the form of preference shares on terms that would punish existing investors if the firms failed to raise new equity.
The scenario was not a new one for equity markets but it underscored the likelihood that a Treasury rescue or mandated capital raise under strained equity market conditions would significantly dilute existing shareholders. The result was that Fannie and Freddie’s shares plunged 22 per cent and 25 per cent respectively on Monday, and continued to drift lower on Tuesday.
A Treasury intervention would also fall short of protecting the mortgage agencies’ subordinated debt, which has contributed to significantly wider spreads for this paper in recent weeks.
The Treasury dismissed the Barron’s report as “speculation”. It told the Financial Times it still had no intention of using its newly authorised power to invest in either the debt or equity of Fannie and Freddie.
Certainly, there are other strong reasons why prices for the GSE’s equity and junior debt have come under pressure.
The GSEs’ second-quarter financial statements created anxiety about losses in prime mortgages on top of the losses in their subprime and Alt-A mortgage books, creating fears that loss ratios for the two GSEs could cause further impairment of their capital positions. The rating agencies responded to this by lowering the ratings on the subordinated debt and the preferred equities.
But the perception of heightened risk around a Treasury intervention was the key driver behind this week’s share price move.
In contrast, such a belief in the near-explicit government guarantee behind GSE credit should theoretically have caused senior agency debt prices to rise and spreads to tighten, as investors should be reassured that their money is safe. This has not happened.
Funding costs for Freddie Mac have surged in the past few months. Freddie on Tuesday paid 4.172 per cent, or 113 basis points over Treasuries, to sell $3bn in five-year notes. That’s almost double what the agency paid to sell $4bn of five-year debt in May. In a $3.5bn issue last week, Fannie Mae paid 122.5bp over Treasuries, its widest spread ever for three-year notes.
While several US fixed income portfolio managers, including Pimco, the bond giant, bet that the Treasury plan would boost prices and lead to tighter spreads for this debt, they are currently playing a waiting game. Prices are falling in the absence of support for agency securities of any kind, the trade is losing money and the Treasury is yet to intervene.
Spreads have in part continued to widen because the traditional buyers of mortgage products have scaled back their participation in the market.
This includes the GSEs themselves and US banks, which have become capital constrained because of mortgage losses, and foreign buyers of agency debt, for whom the uncertainty has encouraged a tendency to buy more Treasuries and fewer agency securities.
Mustafa Chowdhury, an analyst at Deutsche Bank, said: “The structural buyers for mortgage products, for all practical purposes, have disappeared, with the GSEs and the banks basically absent from the market, and Asian investors actually net sellers.”
The latest Federal Reserve custody data shows that for the year to July, foreign official and private investors bought an average of $20bn agency debt per month. Purchases of Treasuries averaged $9.25bn. But from July 16 to August 13, investors have sold $10.7bn of agency debt, trimming their overall holdings to $975bn. They purchased $56.1bn of Treasuries in the same period.
As investors doubt whether the GSEs can increase their portfolios in the current climate, they are selling mortgages, agency debt and swaps. Beyond the safety of US Treasuries, this threatens a cascade of fire sales across fixed income markets and many areas are near the worst levels seen in March, when Bear Stearns collapsed.
Meanwhile, as mortgage spreads continue to widen, the capital positions of the agencies and the weakened banks deteriorate further in what could become a self-reinforcing pattern.
This filters through to the underlying housing market as widening mortgage spreads also have the effect of keeping mortgage rates high – making any recovery in the housing market harder to achieve, promising further losses for the banks and the GSEs, a scenario which could eventually force the Treasury’s hand.
