Thursday, August 21, 2008

Market puzzles - Fannie Mae and Freddie Mac

Crank your mind back to 2006. You are a run-of-the-mill hyper bear (as I appeared at the time). Someone told you that in 2008 there would be a crisis at Fannie Mae and Freddie Mac. The Secretary Treasury would ask for and get an essentially unlimited pool of government money to ensure that the senior debt of those institutions did not fail. [He said nothing about the preference shares or common.]

What would you have thought would happen?

To me it seemed obvious. The senior debt would now be as safe as Treasuries and the spread on the senior debt would come in to maybe 30bps from crisis levels.

But the whole scenario would be very bad for the US dollar because the implied debt of the Federal Government just rose an awful lot.

So what did happen?

Well the spread on Fannie and Freddie securities widened not narrowed, and the US dollar got strong.

The widening of the spreads on Fannie is either irrational or a rational bet that the US Government cannot be trusted to honour its promises. But if it is the latter why is the USD strong?

What is happening now is every bit as weird as what happened in the bubble.


JK said...

I would think that the dollar is strong because holders of US debt (dollar buyers) would feel safer if the US govt did not have to support so many different entities.

steve said...

Given how hard you work to uncover actionable arbitrages it seems appropriate to ask if you have acted on this one. If not, are you being irrational too?

As a first order issue I suspect the reason is simply that most buyers of such paper (in size) are institutional functionaries who are not going to personally benefit from the additional yield but who would have their heads handed to them if anything ended up going wrong. They are rejecting the current ambiguity.

That leaves other adventurers, heggies, or yourself for that matter. Hence, my question.

John Hempton said...

Fortunately I have not acted on this. If I had it would have been a few days ago - and I would be a long way down now.

The spread is 115bps on three year paper - so you make about 3% as the debt converges.

To make a good return on equity you need leverage - and I will not do it.

But there are plenty of unlevered players (bond funds etc). The problem is that the bond fund I admire most (Pimco) acted on this a while ago and is having its ass handed to it.

Levered it would scare the hell out of me... simply because there is a small (I believe negligible but not zero) chance that the Feds will do something to scare the bond holders in the bailout process. Levered that could kill you.


chris said...

Have you ever looked at NLY? It's a mortgage reit that holds mainly agency debt. I buy it on the really scary days. It's either that or RICK.

Anonymous said...

Maybe the assumption that the US will guarantee the debt is wrong and was merely a ploy to convince the market to keep buying FNM bonds?

I am leery of the implicit guarantee. Everyone keeps talking about this but I have yet to see anyone from the government come out and say in simple terms "yes, we will guarantee all senior debt." Maybe the large spread has priced in the risk that the implicit guarantee does not exist in the explicit world?

John Hempton said...

In response to Chris - I have looked at NLY for years. It trades at about book. Its just a hedge fund doing interest rate risk. I guess it is a better buy than paying someone 2 and 20 to do the same thing. But not my scene.

Wake me up at 0.7 times book.


The statements of Paulson et al are pretty unequivocal. The Feds will inject enough equity in to make Fannie whole.

Maybe the US government is not worth its word.

I think it standard that foreigners are now thinking this White House lies. (Remember links between Saddam and Osama? How about weapons of mass destruction? Nuclear plans etc.) That all sounds extreme - but what the market is doing IS extreme - it is telling us that the market does not trust the US government!

I called it a puzzle. I am still puzzled...


John said...

Throw in the fact that it now looks like the estimable American voter is now about to elect a loopy hothead with only a few years left in his holster President.

And...I repeat and...his Vice President, almost sure to become President, will be Joe Lieberman. That's bomb Iran into the stone age, America in Iraq forever, we are all Georgians now, Lieberman.

I wouldn't like to be a foreigner right now. I would like even less to be an American.

Anonymous said...

The dollar index rose despite trader sentiment being anti-dollar. The recent rise was therefore central bank intervention, - a post Bretton Woods Euro soft peg between 1.47 and 1.60. The critical DI level is 72, once hit then the panic button is pressed.

Marc said...

In my opinion the US Dollar is rising in anticipation of (longterm) increased US Inflation. I am not talking about hyperinflation, but a much heftier inflation than what US got used to in recent years. Interest rates would have to rise, hence the rise of the dollar.

Reason why I am convinced this will happen is that the deflationary pressures coming from the shifting of production towards the developing world (China, India) have all but stalled. Instead we will experience chinese inflation pressures on our imported goods, coupled with long term scarcity and thus higher prices for raw materials.

Anonymous said...

FWIW, I think the USD is stronger on unwinding of 6y worth of accumulated short positioning. Consensus longs (AUD, CAD, EUR) fell can check the relative performance vs. a base ccy over a given sample period on Bloomberg; will post if I can remember the function name.

Lee said...

I think the spread has widened because the nature of the guarantee is unclear. It's not that people don't trust the government -- though surely they don't -- it's that Paulson is simply incomprehensible. His language is so oblique he hasn't even ruled out buying existing shares (which is unthinkable!). People use guarantee too broadly. The government fund the GSE's in order to keep them operating but who knows what the equity will look like and who knows if or how the debt will be restructured.

The strong dollar I can't explain.

Anonymous said...

When you buy a new car it's value is reduced as you drive off the lot. Bond holders of GSE debt are now facing a similiar problem except the losses are TBD.

Anonymous said...

Isn't the US dollar rising because of deleveraging. All the excess credit creation in the US is now going into reverse. This has destroyed the capital of US financial industry - which has been busy replacing the vaporized capital. But eventually there is a limit to US dollar liquidity and therefore available capital for the financial industry in the US.

It is also why the US trade deficit is falling -- because all those dollars sent overseas are being repatriated. If the oil price falls suddenly - the US trade deficit could vanish just as suddenly as oil imports make up over 100% of the US trade deficit now.

The rising credit spreads reflect the increasing scarcity of credit availability relative to demand for credit.

I think the US is tipping slowly into deflation which is bullish for the US dollar and bearish for gold and commodities over the longer-term. The whipsaw to everyone going long on commodities and short the US dollar is going to crush the last of any rising asset classes and deflation will settle in suffocating the US economy like a blanket leading to a poor economic performance and possible contraction. This is why the yield curve is falling at all ends of the yield spectrum. We are reaching a tipping point where the lack of US dollar liquidity will start to pinch.

Gloomy said...

Whenever I do business, I get the terms in writing. In order to unequivocally give government backing to the securities, they would need to issue a written, legally binding addendum to all debt agreements specify backing by the treasury. All Paulson did was ensure that everyone knew just how desperate the situation was, without offering a legally binding fix.

VoiceFromTheWilderness said...

Amazing, simply amazing. Now I know why we have the government we have: Americans, even savvy ones, think there is only one country in the whole world - US.

So the problem with your analysis is that you are implicitly holding the rest of the world fixed when you make your 'backward projection'. Sure, if the rest of the world was constant, then in the scenario you paint (which indeed we in the US are living under), the dollar would fall. But...? The world is not fixed, it too is changing, in lots of complicated ways. It's quite clear what has happened in the rest of the world between the two points in time you consider -- the rest of the world, and the major international financial players, have discovered that their attempt to spread risk around has worked. The Eurozone, the asian economies are in fact all intimately tied to the US, and more sensitive to change. Their economies are plunging quickly. So.... The relative stability of the US is now seen as better than it was when 'decoupling' was believed. Mystery solved.

What's really fascinating is how an entire sub-cultre (finance) can believe both that through the magic of derivatives we can 'spread risk around' and simultaneously that the various economies of the world are 'decoupled'. The finance industry has spent 15-20 years 'opening up markets', and promoting 'free trade', and creating giant multi-national financial (and non-financial) entities, so obviously, any fool knows that means... we are decoupled.

Fabulous, just fabulous

Elizabeth said...

I'm late to comment but I think you have the correlations wrong.

The bond market is not stupid - in thinking about the GSE debt, the assumption that some % is just US govt debt (the haircut is because it is has interest in GSE assets which means it is not entirely dependent on US general tax revenues like regular treasury debt).

You might argue that rates don't seem to reflect the perilous financial state of the US govt balance sheet and that would be correct - but its not because the market hasn't noticed the trillions of GSE debt.

Rates and FX rates are both "wrong" because of all the money foreign govts have been spending on various US debt securities.

If the US did not back up the implicit guarantee, these foreign govts who are up to their eyeballs in GSE debt might get very angry and dump or just stop buying US securities. This would be calumitous for the dollar.

So making the debt explicit would in our bizarro world help the dollar.

The trade then (for braver folks than I) might be to buy the debt and short dollar as hedge...

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