Monday, September 8, 2008

Fannie Mae and Freddie Mac nationalization will only indirectly help the financial tornado

The bailout of Fannie Mae and Freddie Mac is a necessary evil to keep the U.S. housing from collapsing, which in its failure, would certainly cause a severe U.S. recession.

According to Ben Bernanke, "I strongly endorse both the decision by FHFA Director Lockhart to place Fannie Mae and Freddie Mac into conservatorship and the actions taken by Treasury Secretary Paulson to ensure the financial soundness of those two companies. These necessary steps will help to strengthen the U.S. housing market and promote stability in our financial markets. I also welcome the introduction of the Treasury's new purchase facility for mortgage-backed securities, which will provide critical support for mortgage markets in this period of unusual credit-market uncertainty."

The question is: Will the government intervention in the mortgage market promote stability in the financial markets? Yes, but only very indirectly. To be sure, the bailout will directly ensure the health of the secondary mortgage market because the U.S. government, which is unlikely to default anytime soon, is now guaranteeing roughly half of the mortgage industry’s loans (about $12 trillion). However, with mortgage delinquency rates at 6.41%, up 1.29% since last year, losses related to assets tied to defaulting mortgages (mortgage backed securities, MBS) will continue to mount. Further, MBS losses will not stop until the housing market stabilizes and home values start to rise, and until then, raising capital to cover the losses is an expensive task. The bailout of Fannie Mae and Freddie Mac will aid in the stabilization of the housing market, but that is still a ways off.

The chart illustrates the Lehman Brothers Corporate spread index for investment-grade bonds, where debt issued by financial companies accounts for roughly half of the index. Other types of debt included in the index are consumer cyclical goods, consumer noncyclical goods, utilities, transportation, and other types of industrial sectors. The spread represents the added yield that the corporate firm must pay on its bond above a U.S. Treasury yield to account for the difference in default rates. The spread is rising precipitously with the increasing probability of financial firms defaulting due to ongoing losses.

The Corporate spread index has reached its highest level since the series was initiated in 1989, 3.08% above a U.S. 10-yr Treasury, and financials with their 42% share in the index, are driving the index. Due to lack of transparency and overbearing counterparty risk related to firm holdings of MBS, financial firms are being forced to raise capital (sell their debt) by offering very high yields. The bailout of Fannie Mae and Freddie Mac will not lower corporate yields; only a stabilization in the housing market that pushes down the risk of mortgage default will lower corporate yields.

The table below shows the losses to date (9/4/08) for the 16 firms with the most capital losses. The main points are: They are all financial firms, losses span the globe, and most of the banks have been unable to raise capital sufficient to cover their losses.

Until default rates recede and the housing market stabilizes (into 2010), losses will continue to mount. When U.S. home values find a bottom next year, the financial tornado that is sweeping through world capital markets will calm down.

However, there are several doomsday scenarios, the most current scenario dealing with option ARMS (see this article), where default rates will mount indefinitely. The bailout of Fannie Mae and Freddie Mac will certainly help to relieve some of the doomsday pressure and push the mortgage market toward a more certain stabilization path. But in the meantime, expect more banks (or investment banks) to fail.

Please leave comments. Best, Rebecca Wilder

1 comment:

  1. Heard the 20yr average of bank failures is 6 a week, 1985 - 2005. Still, the mortgage mess will drive this thing, right? Still keeping our powder dry.


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