Bob Marley on the GSE’s…Everything’s gonna be alright
The Treasury Department released their paper today that outlined potential plans to deal with Fannie and Freddie. I’ll tell you up front that this is going to be a lengthy process with a lot of headline news and no shortage of ignorant/inflammatory statements from politicians on how they are going to handle this. This process will undoubtedly generate a huge amount of interest from boards of directors and shareholders.
I picture a scene where your two smallest shareholders are having lunch and watching TV at a local restaurant. The news-caster says “Fannie and Freddie are going to be dismantled…” As one shareholder chokes on his lunch the other one explains to the waitress that they need their check pronto because the bank is going under. Meanwhile back at the ranch, you, the bank President/CFO/Treasurer are in your office peacefully readying board presentations, reports for the auditors, the call report, loan committee paperwork, and stuff for the examiners. Your phone rings and an all too familiar number pops up on the caller ID. Despite the urge to let it go to voicemail you stop what you are doing and answer it. It’s “two-share Vern” the second smallest holder of your common stock.
Vern stutters and sputters and asks “Is the bank still open?”
You: “Yeah Vern…it’s normal business hours today…have you been drinking?”
Vern: “No but Bob just choked on a sandwich and I heard that our bonds aren’t going to pay us back.”
You: “Where did you hear that?”
Vern: “On the TV.”
You: “The same TV that told you Aliens built the pyramids?”
Vern: “No, that was at the house, this one was down at the restaurant.”
You: “Chill Vern…the bonds are good…there is no logical basis for the bonds to default and besides that, the Treasury has been backing them for a while now, and as recently as this morning, no less than the Treasury Secretary himself said that they will stand behind the GSE’s to ensure they can fulfill all of their obligations.”
Vern: “OK…but do you know how to do the Heimlich maneuver? If you don’t then just make one less copy of the financials for the next meeting because Bob might not make it.”
Nothing new under the sun
Rather than reinvent the wheel on this topic I thought it would be more efficient to give you the very short story up front, and then include a write-up I did last year on this same topic. I’ve written on the topic several times over the last three years and each time it’s been with the same view…your GSE debt is safe.
Treasury Secretary Geithner must have been reading my stuff because today he said:
“As the market improves and Fannie Mae and Freddie Mac are wound down, it should be clear that the government is committed to ensuring that Fannie Mae and Freddie Mac have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations.”
Below is a Market Update piece from March of 2010. This was in response to some very inflammatory rhetoric from Congressman Barney Frank regarding the GSE’s. My hope is that as you get questions from the board and other interested parties you will be able to simply hit the forward button on this e-mail and provide the inquisitors with all the info they need on this topic.
There will be a lot more reporting on this issue as it unfolds. The important thing to note on the front end is that your GSE debt is in great shape, and will be paid back in full. At some point in the future there may be a new entity fulfilling the roles previously occupied by the GSE’s…but that won’t impact the source of repayment of your bonds. The US Treasury has gone out of its way at every turn in this process to let bond holders know that the GSE’s will have the capital they need to fulfill their obligations…that much is known.
If you have any questions on this issue just let me know.
Steve Scaramastro, SVP
800-311-0707
Why Barney Frank is wrong…and I am right
Barney, Barney, Barney…today Mr. Frank is in “fear monger” mode. I don’t know if he is trying to flex a little muscle to get some attention or if he is trying to prove that ignorance truly knows no bounds inside the halls of Congress. This morning he made a statement to effect that the future of Fannie and Freddie debt holders might involve haircuts or bonds not being paid back at all.
Mr. Frank either doesn’t understand the nature of the global financial system, or he’s willing to look like a complete buffoon to get some attention.
Before anyone gets too worked up about Barney’s statements let me point out a few facts, and then we’ll look at why we will never see anything like what he just mentioned.
In the beginning
Fannie and Freddie were created by the by the government, they were allowed to trade in the market with lower risk premiums due to their quasi-government nature (the implied full faith and credit), and they were mismanaged by the government (think “congress appointing their cronies to positions within the GSE’s and forcing them to lower their lending standards and help create this mess in the process”). They have become so large that their debt is distributed throughout the global financial system, and I don’t know of a single bank in this country that doesn’t own their paper. If you buy bonds and you don’t own GSE paper then you are in an exceptionally small minority of institutions. Another material point is that they currently have “unlimited” lines of capital from the US Government. The government owns responsibility of the GSE’s…Barney Frank can’t come out and say he’s bailing anyone out by allowing the GSE’s to meet their commitments. The politicians created the mess at the GSE’s and they are responsible for cleaning it up.
If Mr. Frank thinks that he has the ability to force a “haircut” on the holders of this paper then he needs to be tested for drug use right now. This is a move that would destroy much of the US banking system virtually overnight…it would also extend to foreign countries…some of whom own a tremendous amount of our debt and who would quite willingly punish us by dumping it on the market and causing interest rates to skyrocket.
Secondary effect
Any failure to pay 100% principal WILL result in a downgrade. There is no way around it. Fannie and Freddie would be immediately downgraded to “D” by the ratings agencies. Now a “D” in high school was a passing grade for me…but for the GSE’s it stands for “Default” and it occupies the absolute lowest rung on the credit ratings scale. This downgrade would cause a massive secondary effect.
To help you visualize the impact of a downgrade I’d like you to think back to all of the Gulf War footage we got to see on TV. Footage where an F15 Strike Eagle drops a laser guided 500 lb bomb right on top of a tank…you get the initial explosion which is pretty impressive, but then you get what is called a “secondary”. The “secondary” is where the fun really starts…it’s where all of the fuel and ammo that was onboard that tank blows up as a result of the first explosion. The secondary is what spreads the damage far beyond what would have been done by the initial impact.
The secondary effect from any failure to pay on the part of the GSE’s will come right after the downgrade. Every bank in the country that owns this paper will have an immediate and ginormous loss that runs straight through to capital. If you have 30% of your assets in the portfolio and 80% of that goes into default you’ve got a real problem. Imagine the impact to capital if you have to mark all of your Agency debt from 100 down to say…20.
Your losses will be compounded because you’re not allowed to own “D” rated paper which means you will be forced to realize the loss by selling it. When you go to sell your junk bonds you’ll quickly realize that a crowd has formed because everyone is selling their bonds. More and more people sell which pushes prices lower and lower in what is commonly referred to as a fire-sale. The GSE market will spiral into the deck where it will leave a giant smoking crater similar in size and historical significance to the meteor impact that killed the dinosaurs (I’m watching a lot of Discovery Channel lately so please forgive the analogy). And this is just the impact on the domestic banking system.
Now look at the situation faced by foreign central banks. Some of these folks are ALREADY talking about selling US Securities…this type of action will solidify and accelerate those plans. This will add even more selling. “Panic selling” doesn’t really begin to describe that activity that will be taking place at this point. I wouldn’t expect US Treasuries to be the safe haven after this. I don’t think investors will continue to view debt from the same folks that just blew up the financial system with the GSE default as “safe”.
If you’d like to take it further you could even move on to how many American citizens would have their retirement savings wiped out by this move. It will be tough to get reelected after you torpedo the entire country’s banks, jobs, and retirement dreams. Feel free to come up with some more and shoot them back to me…the possibilities are almost endless.
And do you think anyone would be willing to buy a US “Housing Finance” bond EVER in the future after this fiasco?
Prove it
Lest you think I am merely being an alarmist look at the “secondary effect” we got from the failure of Lehman Brothers. Lehman is a much smaller institution than the GSE’s yet their demise pushed the US financial system to the verge of collapse. When the powers-that-be decided that Lehman was where the bailouts stopped it set in motion a very unintended set of consequences.
Lehman’s default shook the foundation of our economy because their debt was widely held by money market funds. Money markets are tremendously important pools of capital that provide the liquidity for our economy. These funds are the oil in our economic engine. When Lehman defaulted it caused losses in money market funds. Money market funds aren’t supposed to “do” losses. You put a dollar in and you get a dollar out. If you get less than a dollar than the fund “broke the buck” as we say. Breaking the buck is the death knell for a money market fund. So Lehman caused a lot of losses for money market funds. Losses were so widespread that concern that began as a ripple from a corporate bond default, then formed waves, which in turn became a tsunami.
Half of the liquidity in money market funds in the country was poised to leave OVERNIGHT. The sell orders were on the books and ready to be executed when the firms that run the order books raised the alarm. Treasury got a phone call describing the carnage that was about to unfold and they immediately put a Full Faith and Credit Guaranty on all money market funds to avoid the panic. Think about that for a moment…they let Lehman fail and in turn were forced to insure all money market funds in the country against loss. This huge impact was just from the default of a single corporate issuer…Lehman Brothers. This example should provide some very recent insight into what type of events can be triggered by a default of a big institution. If Lehman can do that much damage just think of what the GSE’s hold in store.
In summary
SO…the GSE’s fail to pay or force a haircut, they kill most of the banks in the country in the process (through OTTI capital write-downs on their GSE debt), they anger foreign central banks to the point that they sell their holdings partly out of self defense and partly as a punitive measure, the secondary effect that we love so much roils through to the rest of the investing world in the form massive liquidations in response to the downgrade to “D” and giant swathes of the American public see their retirement portfolios wiped out.
In my opinion there is nobody in politics that is going to light the fuse on that scenario. If your goal were to destroy the US economy and set us on an equal economic footing with say…Kurdistan…then I’d say it’s a good plan. Short of that…ain’t gonna happen.
I believe that my view on the GSE’s is far closer to reality than Mr. Franks’. It seems to me that the most likely scenario is that existing debt of the GSE’s gets “grandfathered” into a Full Faith and Credit status, then they can re-invent the GSE’s and release them into the wild as healthy institutions whose debt going forward will have a much clearer status.
This allows you to avoid nuking the financial system, and at the same time privatize a function that should have been private this entire time anyway. It moves a few trillion worth of obligations onto the Federal balance sheet but hey…that doesn’t seem to bother anyone nowadays.
Wrap it up already
In summary the GSE’s do not have the ability to miss a payment or force a haircut on bondholders. The markets seem to agree with this assertion as well…they are unmoved by Barney’s blabbering today. Don’t lose any sleep over the misguided ramblings of one Congressman.
I’m sorry if I’ve gone on longer than you or I wanted…but I can get passionate about these topics. Halfway through this piece it began looking more like a manifesto of some sort rather than a market update but some things just need to be said. In my view it is pure ignorance for someone of Frank’s stature to be spouting off in such an irresponsible manner on a topic like this. I can only imagine the phone calls his secretary is fielding this morning…most of them from people far more important than me. “Congressman Frank you’ve got Bernanke on line 1, Geithner line 2, Obama line 3, and some fixed income guy from Memphis on 4…”
I hope everyone has a great weekend. If you have any questions or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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