Capital Markets

Still Bleeding

Fannie, Freddie and Lehman ensure August is anything but quiet.
Economist StaffAugust 22, 2008

With blood stocks in New York City low, health officials this month issued an emergency appeal for donations. The lifeblood of financial institutions—confidence—is in equally short supply. Five months after the Bear Stearns debacle, and a month after America’s Treasury unveiled unprecedented steps to support the mortgage market, some whose share prices had only recently hinted at recuperation are again looking dangerously anaemic.

At the top of the critical list are Fannie Mae and Freddie Mac. The quasi-private mortgage agencies are in danger of being overwhelmed by losses on their holdings of mortgages and mortgage-backed securities (MBS). Ajay Rajadhyaksha of Barclays Capital estimates that Freddie’s balance-sheet has a negative value of at least $20 billion when marked at market prices; Fannie is $3 billion in the red. Both saw their share prices fall about 44% between August 18th and 20th as it appeared ever more likely that the government would intervene, wiping out existing shareholders. They are caught in a trap: the greater the risk of nationalisation, the harder it will be for the two institutions to persuade investors to provide an estimated $15 billion of new capital that each one needs if nationalisation is not to happen.

Loss of faith in the firms’ equity is one thing, ebbing confidence in their vast pile of debt is altogether scarier. Spreads on the $1.5 trillion of paper issued on their own behalf have widened. A five-year issue by Freddie on August 19th sold for 1.13 percentage points over treasury bonds, the highest spread for at least a decade. As recently as May, Freddie had found takers at 0.69 points over treasuries.

A sudden pullback by overseas investors is largely to blame. Foreigners, mostly Asian central banks and funds, hold 35-40% of the mortgage agencies’ total debt. They continued to be avid buyers this year, but their appetite waned in the first half of August, and was lower than normal in this week’s Freddie Mac auction. American money managers have taken up the slack, but they too are becoming twitchy about their exposure, according to a market participant.

The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks. The spread on the securities has risen to around 2.2 percentage points over government bonds, even wider than it was during March’s turmoil (after adjusting for today’s lower volatility). This has helped to push up interest rates on the “conforming” mortgages that Fannie and Freddie buy or guarantee, at a time when private finance has slowed to a trickle.

The banks that manage the agencies’ debt issues are pulling out all the stops to ensure their success—even to the point of artificially boosting demand through deals known as “switches”. In such an arrangement, an investor agrees to buy into a new issue in return for being able to sell back to the banks an equal amount of an old one, thus ensuring its net exposure does not rise. If enough of these deals are struck, large amounts of debt can be shifted even when demand is thin. A recent $3.5 billion issue by Fannie was helped along by “very significant” amounts of switching, says one banker involved in it. With $223 billion, or one-seventh, of the agencies’ debt falling due before the end of September, those peddling it will have their work cut out—especially if the Asian investors continue to be put off by unkind headlines.

This is not what Hank Paulson, America’s treasury secretary, envisaged last month when he announced an emergency plan to rescue the twins. By pledging to invest in them if needed, he had hoped to calm markets and thus reduce the likelihood of a bail-out. That gamble looks ever less likely to pay off, however.

If a government recapitalisation does prove necessary, the treasury is likely to take one of two routes: a preferred-stock investment that allows the agencies to raise more capital of their own, or nationalisation through a common-equity injection that leaves current owners with nothing, and thus offers the taxpayer a better deal. Jeffrey Lacker, head of the Richmond Federal Reserve, this week threw his weight behind the second option. Nationalisation would probably also lead to the removal of both institutions’ managements, and undermine the cosy ties the agencies have long had with Congress.

This comes against an increasingly bleak backdrop. Lehman Brothers, the smallest of the four remaining full-service investment banks, is still struggling to persuade the stockmarket, and its clients, that it has a future. Faced with another big quarterly loss, it is hawking around both its worst assets (a toxic commercial-mortgage portfolio) and its best (Neuberger Berman, a fund manager). Selling a chunk of Neuberger would raise much-needed funds, but it would also leave Lehman looking far less diversified and less stable.

This week Goldman Sachs, the only investment bank still in decent shape, cut profit forecasts for all of its main capital-market rivals, including Lehman, citing the need for further write-downs and a drought in key business lines. (Some analysts had cut their Goldman forecasts the week before.) It also released a scathing report on American International Group, putting its losses from mortgage-related swaps at up to $20 billion, and even suggesting the giant insurer could suffer an “impairment of counterparty confidence”. The spreads at which big banks lend to each other, meanwhile, hit a two-month high. One of them may go bust in coming months, mused Kenneth Rogoff, the IMF’s former chief economist, one of a long list of those who think the worst is yet to come. Given what has already been endured, that is a blood-curdling thought.