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Department of Uh-Oh, The End of the Mortgage Agencies
Fannie and Freddie’s preferred shares have been considered so safe that banking regulators let banks count them in the capital required as a cushion against loan losses.
That should read "*had* been considered so safe." Further background is here and here. We also have an impossibility theorem. I do not see how our government can let the value of this preferred stock fall much further, given the extent to which bank insolvency would increase. I also do not see how our government can prop up the value of this preferred stock to a significant degree. Silly me. I guess that means I bet on the latter impossibility.
Here is yet further discussion of the end game. It seems the common stock owners will end up suffering more dilution than they had been expecting. The $340 billion in agency debt held by the Chinese central bank will be protected, as it must be. Have a nice day.
And the newspapers were wondering why the Dow tanked 345 points.
Posted by Tyler Cowen on September 5, 2008 at 10:39 PM in Current Affairs | Permalink
Comments
"And the newspapers were wondering why the Dow tanked 345 points."
Yes, that's certainly a sign that journalist sometimes aren't the smartest people in the room.
Posted by: thehova at Sep 5, 2008 11:07:53 PM
"Yes, that's certainly a sign that journalist sometimes aren't the smartest people in the room."
As opposed to economists.
HC
Posted by: Happy Camper at Sep 5, 2008 11:35:27 PM
No, this has nothing to do with the markets tanking on Thursday. That was just another very volatile day in the markets. 2% swings haven't been unusual lately; that one just happened to be 3% instead.
The endgame for Fannie and Freddie has been widely known for some time: common shares basically go to zero, debt honored in full (China warned of catastrophic consequences otherwise), with the only dilemma being how to handle preferred shares because so many already troubled US banks own large amounts, as you mention. This endgame has been openly discussed in various places in the blogosphere and financial press for at least a couple of weeks now (Brad Setser, Yves Smith of Naked Capitalism, John Dizard in FT, etc... I think even Alan Greenspan has chimed in).
It has also been widely known that foreign central banks have been shunning GSE debt recently, and that is what is forcing the US government's hand in doing this sooner rather than later. Fannie Mae and Freddie Mac need to refinance $225 billion before the end of September, and it was looking unlikely that they'd be able to (see Brad Setser's post from Tuesday).
Basically, everyone knew this was coming, and much sooner rather than later. Well, everyone except some retail investors in FNM and FRE common shares. They can take comfort in knowing that a lot of supposedly smart former investing superstars (Bill Miller, etc) have ridden Fannie and Freddie common shares all the way down too.
Posted by: at Sep 6, 2008 12:05:02 AM
A good summary of stories is at Naked Capitalism. Until the final announcement on Sunday night (before Asian markets open on Monday), there seems to be considerable confusion as to the final details, especially regarding the preferred shares.
Posted by: at Sep 6, 2008 12:23:32 AM
And here is an older story (August 26) from Naked Capitalism, with links to John Dizard's FT article.
Posted by: at Sep 6, 2008 12:42:07 AM
Taxpayers will pay out of pocket to cover preferred stocks? That seems insane.
Posted by: Mercutio.Mont at Sep 6, 2008 3:13:47 AM
Am I getting this right? Banking regulators whose whole job is to provide a sense of security let banks count equity as debt. Mark-to-market rules are changing balance sheets causing unease among creditors. Inflated asset prices facilitated by credit must now come down, but noone knows how much because excessive market values are now replaced by overly conservative market values. Come again how the market takes most of the blame? The problem is noone knew what they bought, but is China part of "the market?"
So, is China in the too big to fail category now? What are the catastrophic consequences? For someone who doesn't see continuing the path that got us here as such a wonderful thing, I find myself tempted to just send China home with some nice parting gifts and a "welcome to the creative destruction club" card.
Posted by: Andrew at Sep 6, 2008 6:25:18 AM
Can I have my money back for Enron and Global Crossing now please?
Posted by: torabora at Sep 6, 2008 7:56:57 AM
I eagerly await hearing why the executives of these companies really did deserve the salaries they "earned" the past five or six years, and how vigilant the boards were.
Posted by: Bernard Yomtov at Sep 6, 2008 9:44:51 AM
According to the WSJ, Daniel Mudd, the CEO of Fannie Mae, is expected to step down as part of the deal.
Out of idle curiousity, does anyone know if he's related to Dr. Samuel Mudd, who was imprisoned for treating Lincoln's assasin? (Also the origin of the phrase "My name is Mudd.")
Posted by: Bob Knaus at Sep 6, 2008 9:57:18 AM
Andrew,
The "catastrophic consequences" among other things, is that foreign central banks would abruptly stop buying agency debt. To some extent, this is already happening (they are shifting into Treasuries instead), until there is a credible bailout to restore confidence. At this point, nothing short of making implicit guarantees explicit will do -- if they try to stop short of doing so, we will just revisit the problem again in a few weeks or months. Arguing moral hazard is beside the point; you can't stiff someone on the money you borrowed yesterday if you need to borrow from them again tomorrow (and the day after, and the day after...).
At the moment, Fannie Mae and Freddie Mac pretty much are the mortgage market, there's no one else left standing. What would happen if no one could get mortgages anymore in the US, except at sharply higher rates? Among other things, real estate prices would plummet (anyone who absolutely had to sell would find a sharply reduced pool of potential buyers). Homeowners with mortgages would find themselves even more underwater than they already are, and would shrug and default in even greater numbers. Holders of mortgage-backed securities and CDOs, already crippled, would face collapse.
The federal government can bail out Fannie and Freddie, or they can bail out half the banks in the country.
The scary part is that even a full bailout here might not be enough. There are further dominos yet to fall, elsewhere.
Posted by: at Sep 6, 2008 9:58:16 AM
"For someone who doesn't see continuing the path that got us here as such a wonderful thing, I find myself tempted to just send China home with some nice parting gifts and a "welcome to the creative destruction club" card."
Agree. You rolls your dice you takes your chances.
Posted by: meter at Sep 6, 2008 11:09:53 AM
Agree. You rolls your dice you takes your chances
This cuts a lot of different ways.
We rolled the dice by running up massive deficits, a big part of which are financed by the Chinese. Now it's not a good idea to stiff them on other debt they hold.
You can default on your Visa bill, but don't expect it not to have consequences for your credit.
Posted by: Bernard Yomtov at Sep 6, 2008 11:45:25 AM
Agree. You rolls your dice you takes your chances.
To borrow an overused phrase, you just don't get it. Do you realize how heavily the US depends on capital from overseas, on what Brad Setser has called the ongoing "quiet bailout" of the US economy, primarily by the Chinese?
When the Chinese warned of "catastrophic consequences", that was not a plea asking to go easy on them or give them a break. It was the equivalent of admonishing turkeys not to vote for an early Thanksgiving.
Posted by: at Sep 6, 2008 12:12:25 PM
WaPo says that the govt will protect the preferred stock and dilute, but not wipe out the common.
Insurance companies have a lot of preferred on their balance sheets as well, although not enough to affect solvency or claims paying ability if the value of the preferreds go to zero.
(Don't have the WaPo link, but it should be in today's version/issue.
Posted by: DougM at Sep 6, 2008 1:07:49 PM
There should be at least a haircut for holders of FRE&FNM debt.
Posted by: Mercutio.Mont at Sep 6, 2008 1:20:14 PM
The Federal Government (and therefore the US taxpayer) is stuck with this because it is the world's largest current borrower; and by far the largest debtor. The USA has no dice to roll. Looked at another way, shifting Fannie and Freddie's debts - their preferred has been treated as debt - and assets to the Federal Government's balance sheet is simply more honest accounting. The taxpayers' eventual paper loss(profit) is the amount of the eventual excess(shortfall) of debt to assets.
Posted by: David Heigham at Sep 6, 2008 1:31:37 PM
What would happen if the US did not backstop Fannie and Freddie? How bad would it really be? All the holders would take a bath, but not that big a one. 10%? 20%? The houses are still worth something.
Central banks wouldn't buy anymore paper from companies with implicit US gov guarantees. Good. Why should they?
Mortgages would become more expensive. Good. They should be. If rates go high enough, someone will lend.
Is it just me, or would this provide a great demagoguing opportunity, for either Obama or McCain? Why should we bail out Chinese bondholders? That is hardly a political winner. Either Obama could shift the focus to the economy and Bush always helping the rich or McCain could have a great way of separating himself from Bush.
Posted by: David at Sep 6, 2008 1:36:54 PM
I suspect some readers are confused about the meaning of "preferred stock". Preferred stock is not stock at all. It is a bond issued by the company, which has an option to pay off the value of the bond in shares. It carries no voting rights.
Posted by: David Wright at Sep 6, 2008 3:33:48 PM
Wait, the US wants the Yuan to appreciate in value, and when they are given an opportunity to do so on a plate, they do the exact opposite by bailing out the Chinese central bank. That's so confusing!
Posted by: kurt at Sep 6, 2008 3:34:47 PM
Shareholders of mortgage reits, financial companies, and most of the market will be very richly rewarded come monday if the gubmint takes over the GSE's. Market should rally strongly.
Posted by: bill at Sep 6, 2008 3:40:28 PM
David Wright, preferred stock is not a bond. It has rights to dividends ahead of common stock, but it goes on the equity portion of the balance sheet, not the debt.
Tyler, can you do one of those instant polls:
"Should the U.S. Government refuse to guarantee Fannie Mae/Freddie Macs debt, thereby causing the government of China to suffer a several hundred billion dollar loss?"
Posted by: TomHynes at Sep 6, 2008 6:43:47 PM
TomHynes: Prefered stock pays a fixed dividend (i.e. like a bond yield). If it just paid a normal dividend, having dividend rights ahead of normal stock would be meaningless, since the corporation could simply declare a zero dividend. That, combined with its lack of voting rights (i.e. like a bond) and the option to repurchanse at a fixed face value (i.e. like a pre-payable bond), makes it much more like debt than equity, regardless of what accounting rules say it is.
Posted by: David Wright at Sep 6, 2008 8:40:07 PM
Oh, and one more thing about preferred stock: if you've ever owned any, you'll know that, unlike common stock, its spot price doesn't track the fortunes of the company. If the company has a banner year -- quadrouples its sales, triples its profit, doubles its common stock dividend -- the price of its prefered stock mostly won't budge. (That's what you would expect, too, since prefered stock's fixed dividend won't increase.) Instead, the price of prefered stock tracks yields on corporate bonds, just like the price of treasuries tracks interest rates. (The fortunes of the company do come into play insofar as they affect default risk.)
Posted by: David Wright at Sep 6, 2008 8:55:49 PM
"To borrow an overused phrase, you just don't get it. Do you realize how heavily the US depends on capital from overseas, on what Brad Setser has called the ongoing "quiet bailout" of the US economy, primarily by the Chinese?"
a) I'm not sure how much we can count on the Chinese to invest in our bailouts in the future no matter what the Treasury does.
b) If the Treasury replaces the (governmentally run) Chinese banks as lender of last resort for bailouts, is that in reality worse for us? (I'm asking, I don't know the answer to that, but I'm sure you don't either.)
Posted by: meter at Sep 7, 2008 9:38:37 AM
