It seems remarkable, given the lurid headlines and negative reactions, that the Lehman Brothers’ equity research on Fannie and Freddie published at the beginning of July suggested that the agencies’ underperforming stocks were good value over the long term.
Not many in the market, especially not the authors of the report, believe that new accounting rules (FAS 140), which would require many billions of additional capital, would be imposed on the government-sponsored enterprises. Nevertheless, the market decided to pick up on the vague possibility of an additional $46 billion and $29 billion of capital being required for Fannie and Freddie respectively, and ignore the protests from the government sponsored enterprises’ regulator, OFHEO, that it would not countenance such new accounting regulations.
It seems that the market was searching for any good reason to hammer these two entities. And it received plenty of help from former Federal Reserve Bank of St Louis governor William Poole when he said that the GSEs were technically insolvent. Poole’s comments have some credence. On a fair-value basis, their liabilities are probably far greater than their assets. Nevertheless, his comments were akin to shouting “fire” in a packed auditorium. The market sold off dramatically and a so-called bail-out was quickly organized.
The bail-out was not much more than spin. The US taxpayer has always stood behind the agencies – at least implicitly. But now the guarantee is becoming more explicit. Perhaps that is a good thing, because now the true cost of the subsidy that the government was providing to the US housing sector will become apparent.
The most incongruous aspect of the demise of Freddie and Fannie is that they have never had a hard time funding themselves. Note that Freddie had little problem getting away $3 billion of two-year money on July 17. Their credit spreads have remained impressively close to the Treasury curve.
It’s worth thinking about what it is that causes a financial institution to become bankrupt. The first is that it cannot fund itself. The other is that it has insufficient capital. But it will be many years before Freddie and Fannie will be pressed for capital. That said, it seems certain that they are in trouble – like the rest of the US financial sector.
Over the years, the two companies have been justifiably criticized for their accounting processes and their distortion of the housing market. And yet the period from 2005 onwards – when sub-prime excesses were at their height – was one in which their traditional role of providing affordable housing for Americans was constrained by regulatory edict. It was probably a coincidence that RMBS stepped into the void left by them just as a raging bond bull market was in full flow.
It will be ironic, as US regulators look to reshape their financial infrastructure, if one of the biggest casualties is the role of the GSEs.
