FOR many Americans, Sunday is for church, family lunches or catching a ball game. For the country’s financial authorities, it has become the day of the dramatic announcement: the takeover of Bear Stearns; the Treasury’s promise in July to stand behind Fannie Mae and Freddie Mac; and, most momentous of all, on Sunday September 7th, what had recently come to be seen the inevitable culmination of that pledge: the government’s seizure of the two giant mortgage agencies.
Hank Paulson, the Treasury secretary, had hoped that the July announcement would calm nerves sufficiently that he would not have to take out his “bazooka”. The opposite happened. The firms’ shares collapsed amid fears that investors would be wiped out in a government rescue. This severely curtailed their ability to issue much-needed capital, also infecting their mortgage-backed securities and the $1.6 trillion of debt they had issued to buy mortgages for themselves. It was only a matter of time before the government was forced to launch its largest-ever financial rescue.
Though some had wanted to see the agencies fully nationalised, obstacles stood in the way—not least that this would have required an act of Congress. So the Treasury had to get creative. The plan has four planks. First, Fannie and Freddie will be taken into “conservatorship”, a watered-down form of receivership, by their revamped regulator, the Federal Housing Finance Agency, until they are once again “sound and solvent”. Second, they will have access to a loan facility, secured against their assets, until the end of 2009. Intriguingly, this will also be available to the 12 Federal Home Loan Banks. James Lockhart, the FHFA’s head, stressed that these bank-owned co-operatives, also designed to grease housing markets, are mostly in good shape. But they have a lot of short-term debt and the quality of their borrowers’ collateral is falling. Allowing them to tap the credit line may be a shrewd precautionary measure.
The third plank highlights Mr Paulson’s wish to protect the taxpayer and avoid “moral hazard”. The Treasury will buy preferred shares as needed, whenever the agencies’ net worth dips below zero, and this paper will be repaid ahead of their existing preferred and common stock (whose dividends are being eliminated). Lowly shareholders could yet lose everything.
Indeed, the deal could have been a lot worse for the taxpayer. In exchange for vowing to keep the firms above water, the government will receive $1 billion “fee” in preferred stock at no cost, along with warrants giving it the right to 80% of the firms’ common stock at a nominal price. The two chief executives will leave. Fannie and Freddie, whose unparalleled political connections helped them to keep regulation toothless and expand on threadbare capital cushions, will no longer be allowed to lobby lawmakers.
The final piece of the plan may unnerve some taxpayers. To keep mortgage markets chugging along, the Treasury will become a buyer of last resort for bonds packaged by the agencies, purchasing them in the open market if demand slackens. Could it end up burdened with piles of toxic paper? Mr Paulson was upbeat, pointing out that since the Treasury would hold the securities to maturity it might one day reap net gains.
But the eventual cost to the public purse is unknown and potentially huge. The Treasury says it could buy as much as $100 billion of preferred stock in each of the two firms, though it deems that highly unlikely. Ultimately, the size of the bill will depend on their ability to recover, and that is far from clear. Under American accounting standards they have adequate capital, despite the rapid deterioration of their portfolios. But on a fair-value basis, marking their assets to the current market price, Freddie is insolvent and Fannie not far off. Moreover, with house prices still sliding and foreclosures rising sharply, worse may be ahead.
It’s going to be really interesting to see how the markets react to this news today … and it might end up being a good deal for the taxpayers in the long run; but with some short-to-medium term pain for banks and investors.
Thus far, the government’s commitment is $200 billion … and there is no guarantee that they’ll have to shell out that much. To put that amount into perspective; as of September 2007, the war in Iraq was costing $720 million per day … $200 billion is about 278 days of the war, a tad more than 9 months. The war could end up costing tax payers between 2-3 trillion dollars; 10-15 times that of the mortgage crisis.
The entire mortgage market is currently estimated to be $11 trillion dollars; this means that the bail-out is for less than 2% of the entire market. With the way that the market has been swinging lately; I make and lose more than that in a day sometimes.
My gut feeling is that most investors are panicking needlessly, assuming that all the loans in these various companies’ portfolios are bad. I think, however, that most homeowners will do everything they can to pay their loans; in the short-term, foreclosures will continue to rise, but with plans being developed to help homeowners’ re-finance their loans, given a few more months things should settle down.
When it comes right down to it, banks would rather take a small loss on loans by re-financing at market-prices; rather than foreclosing, and auctioning off a house at prices that are well-below the going market-rate. And most homeowners would rather stay in their properties if at all possible, doing everything they can to make the payments, rather than losing their homes.
Banks are getting more conservative, and are requiring better documentation before approving loans. Home buyers are buying smarter; trying to get something they can afford, rather than getting the biggest and most expensive house they might possibly be able to get. And the fact remains that it’s really only at the upper-end that housing prices are falling. At the lower-end and middle of the market, prices are stable … either rising very slowly, or stagnant, but not really falling.
Investors just need to step-back a bit, get rid of the worst junk in their portfolios, and ride it out, because it will get better … and getting off a roller-coaster in the middle of the ride is dangerously stupid.