Mortgaged hope

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The most surprising aspect of the rout in Fannie Mae’s and Freddie Mac’s shares this week is that there were still investors holding out hope for their equity in the government sponsored enterprises.

This optimistic crowd have enjoyed brief periods of respite during a year in which Fannie and Freddie have shed more than 80 per cent of their value. Given that the two GSEs ought to be using any uptick to try to raise fresh capital, a process that would dilute existing investors, holding on at this point is an exercise in masochism. Even if the prospect of raising fresh equity in the usual way is moot when Fannie’s and Freddie’s combined market capitalisation amounts to all of $9bn, their free-falling stock prices help bring forward the day that the Treasury Department has to step in, wiping out equity holders completely.

The GSEs may be adequately capitalised according to their regulator’s current definition. But there are big question marks over the quality of their balance sheets, relating for example to their use of deferred tax assets. This is, in part, why the rot is spreading up the capital structure, with Freddie’s latest benchmark five-year bond priced yesterday at 113 basis points over Treasuries, the biggest spread ever. This speaks to another worrying trend: signs of reluctance among Asian central banks, buyers of last resort du jour, to keep taking GSE paper. Only 31 per cent of Freddie’s latest issue went to Asian investors, down from 41 per cent in May. Other auctions this year have shown similarly weak allocations to Asia.

Wider spreads on GSE debt mean higher mortgage charges, which continue to climb regardless of rate cuts by the Federal Reserve. A dangerous spiral could see costlier mortgages deepen the malaise of the housing market, increase the GSEs’ losses and raise their cost of capital, and so on. For the authorities, avoiding this outcome trumps any qualms about current shareholders’ desires. Intervention of some sort looks inevitable – the only question is whether this thankless task will be left to the next US administration.

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