“(The “implicit guarantee”) describes a peculiar belief widely held before the financial crisis, that Fannie Mae and Freddie Mac would be rescued by the government if they fell into distress. Despite evidence that this idea enabled them to borrow at rates close to Treasury yields, government officials denied any such guarantee existed – right up until they rescued the two of them in 2008…

…Now it looks like that belief endures, with risks for investors, regulators and taxpayers.” Wall Street Journal, June 24, 2014

“At the heart of the financial crisis stands our government’s well-intended distortions of free and fair markets. Among those are federal deposit insurance, federally-guaranteed mortgages and other loans, and the “implicit guarantee” of Fannie and Freddie’s debts. At IndyMac, we believed the government when they denied this guarantee existed and acted according to this belief by rationally investing in private AAA MBS. They had the same credit ratings as AAA Fannie and Freddie MBS, but also had 5% to 10% of the bonds (collateral) which were subordinate to (and protective of) AAA, and in some cases private bond insurance providing further credit protection. Private AAA MBS also had the same bank regulatory capital requirement as AAA Fannie and Freddie MBS. And yet they had a slightly higher yield: not because of perceived credit risk issues, but primarily because of liquidity risk (a key risk banks take on); the Fannie and Freddie MBS markets were much larger and more liquid. Bottom line, if you believed the government’s pre-crisis denials and had stable bank funding, it was clearly rational to invest in AAA private MBS over AAA Fannie and Freddie MBS. And yet the government bailed out  Fannie and Freddie to the tune of $180+ billion; but really the government bailed out all of the investors in Fannie and Freddie MBS and unsecured debt, who were paid 100+ cents on the dollar. And those investors, like IndyMac, who believed the government and had rationally invested in private AAA MBS were left to fend for themselves, as these securities traded at huge discounts to par, driven down by both legitimate credit concerns and panic; partly fueled, I believe, by short sellers coordinating together on their trading activities. (The significant recovery in private MBS prices in recent years, even without any government mortgage programs for private mortgage borrowers, bolsters my arguments here.)” Mike Perry, former Chairman and CEO, IndyMac Bank

Heard on the Street

Haunting Bonds of Frannie

By John Carney

A specter once thought exorcised from the housing finance market may be haunting it once more: the “implicit guarantee.”

That describes a peculiar belief widely held before the financial crisis, that Fannie Mae and Freddie Mac would be rescued by the government if they fell into distress. Despite evidence that this idea enabled them to borrow at rates close to Treasury yields, government officials denied any such guarantee existed—right up until they rescued the two of them in 2008.

Now it looks like that belief endures, with risks for investors, regulators and taxpayers.

Fannie and Freddie began issuing a new type of bond last year to test investors’ appetite for mortgage risk. The bonds promise a stream of payments linked to the performance of a pool of mortgages guaranteed by the two companies. Unlike traditional mortgage-backed securities, these bonds don’t have any collateral backing them. Instead, they are synthetic, with payments linked to how the relevant mortgages perform. As mortgages go bad, the amounts due to bondholders can shrink.

The bonds sold well and have made money for initial investors as their price has risen.

The yield on Freddie’s triple-B-rated bonds was recently less than one percentage point above the London interbank offered rate, or Libor, a benchmark interest rate, according to Wells Fargo. The spread for Fannie’s triple-B bonds has narrowed to 0.67 percentage point.

These yields are now much tighter than most other classes of similarly rated securities. For example, investors could get an extra 2.5 percentage points of yield by buying similarly rated bonds backed by auto loans, Wells Fargo notes.

Yet those ultralow yields may undercut the very rationale for these bonds. After all, the bonds—Freddie’s are called “Structured Agency Credit Risk” securities, Fannie’s are “Connecticut Avenue Securities”—are “credit-risk sharing” instruments. They are meant to transfer some of the risk of default on the underlying mortgages to investors. That should make them less likely to draw on taxpayer funds committed to supporting the mortgage giants. The low yields, though, suggest investors don’t believe much risk is being transferred at all.

They may just think the bonds are safer than the triple-B ratings indicate. But that would mean the bonds aren’t really measuring investors’ appetite for default risk and aren’t meaningfully reducing the risk held by the mortgage giants. They would merely be transferring income from the companies in exchange for upfront payments and the formal acceptance of minimal risk.

Another explanation is more disturbing: Investors may believe that Fannie and Freddie would support the bonds even if the default triggers were tripped. The bond terms would allow Fannie and Freddie to cut payments, but there is nothing that would legally stop them from unilaterally waiving payment reductions, effectively bailing out bondholders. The companies would have an incentive to do so. Allowing a credit event to cut payments to investors might snuff out interest in the bonds altogether.

The tax section of the bond documents suggest there isn’t much risk of not getting paid. The firms both expect that payments under the bonds will be favorably treated as “qualified stated interest” payments, because the likelihood of reductions in amounts owed to investors is so “remote” that they can be considered unconditional payment promises.

While existing bondholders may like the notion of an implicit guarantee, prospective investors and regulators should be wary of history repeating itself. At the least, there is reason to doubt that these bonds have made Fannie or Freddie significantly safer from mortgage defaults.

Posted on June 24, 2014, in Postings. Bookmark the permalink. Leave a comment.

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