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Friday, July 11, 2008


moving to a new form of mortgage finance

minyan peter assesses the future prospects for the american mortgage finance market.

The US Government will not explicitly guarantee the debt of Fannie and Freddie, but rather will either inject capital (super senior preferred stock subordinated debt a la a Continental Illinois style bailout) or provide a “make-whole” guaranty on the assets of both companies (a la an FDIC/RTC style failing bank resolution). The choice of the former suggests a “going concern” for the GSEs, while the latter suggests an orderly wind-down.

In either case there's considerable historical precedence. And either choice implies that the common stock of both companies is worthless and the preferred stock value is at best uncertain.

If Freddie and Fannie are placed into conservatorship and are wound down (the second choice), I expect that the US mortgage market will move quickly to the covered bond format that is common to the Europe mortgage market. (And for a quicker primer click here.)

I believe that Hank Paulson began laying the public groundwork for this on Tuesday when he stated at the FDIC conference that “…as Treasury seeks to encourage new sources of mortgage funding in the United States, improve underwriting standards and strengthen financial institutions' balance sheets, covered bonds have the potential to serve these purposes and reduce the costs for first-time home buyers, and for existing homeowners to refinance.”

this is an eminently reasonable line of thought. but its consequences are disturbing.

i often say that FNM/FRE will be nationalized, but what is nationalization? in this case, as minyan peter suggests, it probably does not entail moving the GSEs onto the government balance sheet. they are too large, their funding requirements too onerous for a government already deeply in debt, for that to be the first option.

moving to a covered bond format in the distant future seems very possible, but what are its near term ramifications? this is private finance, and the covered bond market in europe has been shuttered for a year. capital is currently too threatened to step into a quagmire of highly questionable valuations and bottomless house price forecasts. so the chances of a workable covered bond market in the near term seem very remote to me -- and if one is attempted, i would expect the flow of capital to mortgage markets to be severely restricted.

while this is sensible capitalism, government is highly unlikely to allow the scenario to unfold so disruptively without massive intervention. rather than putting FNM/FRE into runoff, then, and making that transition, i would expect the former -- a capital injection to prop up government's favorite housing policy tools. given the movement in equity prices, that injection is likely to come sooner rather than later -- again, as minyan peter suggested, before monday's open. this will allow congress to seek a more permanent solution while continuing to allow FNM/FRE to support the mortgage market in which it is now at least 80% of the activity.

plenty of discussion on the web. calculated risk notes that an outright debt guarantee is a potentially friendly solution as, despite the balance sheet size, the imbalance of assets to liabilities is (at this stage, anyway) not overwhelming. i suspect the markets would treat it with much suspicion, however -- see john jansen -- and it would in any case represent another example of government going to the credit well and thereby forcing private credit need to thirst. he doesn't see the point of conservatorship, which is the initial direction of the white house per the new york times (via yves smith). mish considers the mess too big to bail. paul kedrosky and david merkel weigh in as well, with merkel making the important point that the federal reserve is essentially powerless here due to the immense size of the GSEs, which dwarf the central bank, and the dire nonexistent likelihood that the fed would print enough currency to expand itself to relevant size.

merkel, moreover, looking to the intermediate term:

Two notes on the politics here: the Bush Administration wins, and loses. Wins, because they end the dominance of the GSEs in a bigger way than they ever could have imagined. Loses, because they can’t use them to support the mortgage market any more. Can the FHLB pick up the slack without them? I doubt it, at least not fully. The FHA isn’t big enough either.

minyan peter writes that FHA and FHLB will step into the gap, but merkel notes that they won't be big enough to fill it completely. mortgage markets are likely to see a decrease in the capacity to make mortgages here barring radical congressional action to expand federal borrowing to bolster FHLB. even then, would private banking expand to make the mortgages? the implication is more gas on the housing bonfire.

UPDATE: to underscore market aversion to a government takeover of FNM/FRE, per john jansen today saw treasury securites crumble on the possibility of a GSE debt guarantee by the treasury. in parallel, credit default swaps on the united states treasury (yep) surged to a record high. given these signals, it's that much more likely that instead the GSEs are infused with capital at some point.

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