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Inflation vs. deflation. Yield curve flattening vs. steepening. These are the prosaic questions fixed-income investors have to ask in the light of the GSE (Government Sponsored Entities) crisis and of other evidence of the strangling effect of the mounting credit squeeze on the US economy and, consequently, on the rest of the world. Let us first, however, add our thoughts to the many comments written about the crisis surrounding Fannie Mae and Freddie Mac. |
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The GSE problem is about both liquidity and solvency. The US Administration is focusing its immediate efforts on solving the liquidity problem, but is still coy about whether its guaranty of GSE debt is implicit or explicit. Many commentators take the implicit guaranty for granted and as sufficient to bring back the GSEs’ credit worthiness (as measured by CDS) to the official AAA rating each GSE carries. We are a little sceptical and wonder what the Asian central banks are thinking after buying agency bonds in recent years to receive a touch more than Treasuries. Nevertheless, the liquidity problem seems to be relatively under control. |
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Not so for the GSEs’ solvency. Already their leverage is enormous: in the order of a debt to equity ratio of over 60. Yet even that equity is highly suspect. The assets include level 3 securities, tax-loss carry forwards valid only on return to profitability, and CDOs written down far less than similar assets held by banks (6% vs. about three times this for the banks) . In addition there are legitimate doubts about the hedges taken out (look at the unfolding CDS crisis). Overall, the true net worth of the GSEs is negative. Are private investors likely to provide the equity investments required to build a solid balance sheet? Paulson knows full well that the answer is “no”, and he has therefore requested Congress to authorise direct equity investment in the GSEs. That is nationalisation by another name. At least the shares acquired or commandeered will be quite cheap! |
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Nationalisation implies much more than “simple” government take-over of management; it means taking on the GSEs’ debt, a figure in the order of USD 5 trillion. A guaranty of the GSEs’ debt while leaving them in private hands (if possible) still implies a massive explosion of Federal debt, more than doubling the accumulated US sovereign debt outstanding. Imagine the burden of interest payments, on the taxpayers and/or new T-Bond issues, and see where all that must lead the USD. |
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The GSE problem is so severe that other issues, normally of great import, are passing almost unnoticed, e.g. the likelihood of further bank failures like that of IndyMac, and the obligation of many banks to buy back municipal bonds downgraded along with the monolines. |
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To return to our opening questions: we are leaning more and more to the view that recessionary forces will overcome inflationary pressures in a matter of months. The implication for fixed-income investors (apart from the obvious one of staying with quality) is that lengthening maturities is beginning to make sense. A mounting recession, spreading from the USA, is likely to lead to a flatter yield curve or simply one which is lower across the board, rather than to steepening. That spells lengthening average maturities. |
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We cannot but observe that the US authorities are reacting to the unfolding crisis like firemen rushing to put out fire after fire. It is clear that there is total reluctance to face up to the major adjustment that the USA must go through to return to a balanced and sustainable economy and a position in the world reflecting its share of wealth generation. The pretence that all is well, that consumers can just go on borrowing to spend (credit cards, tax rebates), that this is a normal recession which will soon correct itself, cannot last beyond the end of the Bush Administration. We hope so, at least, for the long term health of both the USA and the rest of the world. |
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Focus |
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(?) EUR: new record high against the USD (1.6038) |
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(-) Spain: inflation has risen to 5.1%versus 4.7% in May |
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(!) China: Foreign exchange reserves have reached USD 1.8 trillion |
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(-) Housing: Unsold homes, 4 million in USA, 1 million in Spain and 105,000 in France |
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(+) New issues: despite the illiquidity of the secondary market, new corporate issues of short maturities are being well received |
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(!) SEC: rules against naked short selling of the shares of financials are being reintroduced |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question |
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