Dollar bond investors have a problem. America's budget surpluses are slowly killing off the US treasury market. Foreigners hold over 40% of privately held, marketable US treasury debt. That comes to about 18% of America's GDP. Most projections show that all US treasury debt will fall to much less than that within 10 years. And the White House goes even further. It's saying that America's national debt will vanish by 2015.
Taking up the slack will be the country's GSEs - or government-sponsored enterprises - which will overtake the US treasury for the first time next year in the amount of debt outstanding in the market.
These issuers are confident that their securities provide a valid alternative to US government securities. "There aren't many issuers worldwide," says Peter Horvath, the director of debt securities marketing at Freddie Mac, "that can provide the combination of volume, regularity, frequency and top-quality credit rating to give the market the characteristics that they're going to seek in US treasury
surrogates."
Freddie Mac - the Federal Home Loan Mortgage Corporation - is America's second-largest GSE. Freddie has signalled that it will issue $40 billion of its so-called reference notes this year, with issuance around the middle of each month. Reference notes are not callable and have maturities ranging from two to 10 years. Fannie Mae - the Federal National Mortgage Association and Freddie's larger competitor - plans to issue virtually the same amount of its similar benchmark notes.
"We have achieved a lot," says Linda Knight, senior vice-president and treasurer at Fannie Mae. "The key attributes which make our securities liquidity alternatives are deal size, price transparency, tight market-making and a repo market. All of those things exist in the world of Fannie Mae benchmark notes."
The supply of would-be treasury lookalikes is far smaller than the amount that the US treasury has taken out of the market in the past few years. But Horvath points out: "It's far larger than other issuers are supplying to the market in all their debt combined."
Fannie and Freddie have been pleased by growing interest in Europe. Many previous yield differentials in the region have converged with the birth of the euro. So fund managers need to cast a wider net in the effort to add value.
Greg Parseghian, Freddie's chief investment officer, predicts that the GSEs will be successful in many of these areas. "The size of Freddie's issues is now coming into the realm that is competitive with treasuries," he says. "And both the predictability of issuance and the spectrum are now moving toward that level as well."
Freddie Mac's Horvath sums up: "We would obviously like to get a little bit closer to treasuries." And sure enough, the market is starting to distinguish between Freddie's reference notes and Fannie's benchmark notes on the one hand and other dollar debt from spread product issuers on the other. "In that sense," he says, "we are part of the way there."
But GSE paper will never be the same as treasuries - and investors should beware the differences.
Privileged position
Congress set up GSEs in the 1930s to create a secondary market for high-quality home mortgages in order to lower the cost of borrowing for home buyers. Yet, the agencies' federal charters prevented them from expanding into markets which, according to congress, worked adequately. In return, the agencies enjoy a number of privileges.
GSE securities are 20% risk weighted or more. The agencies are lobbying for better treatment but are unlikely to get it. Even in the US it is recognized that Fannie and Freddie, the Federal Home Loan Banks as well as thrifts and commercial banks face capital and risk-modelling standards different from those of the sovereign.
"Risk migrates to the place where the government is least equipped to deal with it," observes Thomas Stanton, a Washington attorney who once worked for Fannie. "The failure of the S&L industry and the imposition of the Basle capital standard on the remaining thrifts chased hundreds of billions of dollars of mortgages from the primary market to the secondary market," he says. "That's where we didn't have effective regulation or comparable capital standards under the Basle Accord."
However, the most important difference is that GSE debt is not government guaranteed. "Investors take it as a given that the US government stands behind the GSEs," says William Oliva, a managing director at Salomon Smith Barney, "even though they say in plain English that their securities are not backed by the full faith and credit of the United States."
Investors' confidence is based on the government's treatment of the savings and loan defaults of the 1980s. S&L depositors had always considered the US treasury to be the de facto reinsurer standing behind Federal Savings & Loan Insurance Corporation. Congress subsequently converted that assumption into a de jure reality when it stepped in and set up a new agency - the Resolution Trust Corporation - to take over insolvent thrifts.
Oliva cites two other examples where the government took action to protect bondholders that did not have full faith-and-credit backing. Congress created a new institution - the Financial Assistance Corporation - to issue in the marketplace backed by the full faith and credit of the US when the Farm Credit System was in trouble during the 1980s. FAC then used the proceeds to shore up institutions in the Farm Credit System.
And congress used explicit language in the Student Loan Marketing Association (Sally Mae) privatization act of 1996 which recognized the special status of GSE debt. That law provided, among other protections, that any outstanding obligations must be replaced with US treasuries under some circumstances.
"Fannie Mae and Freddie Mac," says Stanton, "are too big to fail by an order of magnitude, in terms of the contingent liability to the federal government. "
However, the fact remains that the US government does not guarantee the debt and Francis Cavanaugh, a retired senior treasury official, wonders whether foreign investors will be comfortable with the implicit-guarantee concept. The notion that everybody knows that Fannie and Freddie are guaranteed by the government when US law specifically says that they are not can be a tough sell. "That's going to be a bit of a problem," he predicts, "as foreigners find that there aren't enough treasury securities."