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How fragile is the US financial system?

By Satyajit Das
September 20, 2008 18:30 IST
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The US Treasury's 'rescue' package for the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), collectively the 'Agencies' or Government Sponsored Enterprises, elicited a spectacular reaction from financial markets.

In a triumph of hope over experience, markets betrayed their essential 'romanticism'. As John Maynard Keynes observed: "It is necessarily part of the business of a banker to profess a conventional respectability which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men."

Under the bailout proposal, the government will commit to purchase (up to) $100 billion in 10 per cent coupon preferred stocks in the company, consisting of an initial commitment of $1 billion and warrants for 79.9 per cent of common stock.

The aim is to maintain positive net worth of the entities. The government will also provide funding to Fannie and Freddie secured against mortgage-backed securities issued by the GSEs and the Federal Home Loan Banks.

The plan falls short of a full faith unconditional US government guarantee of GSE obligations. There are advantages tactical advantages in this arrangement. Continuation of Freddie and Fannie as "implicitly" but not "explicitly" guaranteed entities creates a cover of "plausible deniability" for the US to pay higher costs on its borrowings without increasing the cost of Treasury bonds.

The government actions benefited Fannie and Freddie senior debt holders as credit spreads on the bonds tightened due the US Treasury support. Subordinated debt holders also receive a "get out of jail" card as the proposals cover these obligations.

Subordinated debt is normally treated as equity or near equity and would not normally have benefited. Common and preferred stock holders suffer through dilution and the suspension of dividends.

Under the conservatorship, the GSEs are to be managed to meet their obligations rather maximise shareholder returns. It is difficult to see a significant recovery in the value of these securities in the near term.

The government actions address the supply of housing finance. The grand mal seizure in securitisation means that the availability of non-GSE mortgage finance has become extremely restricted. A failure of Fannie and Freddie would have exacerbated the deep-seated problems in the housing market.

The US also needs to maintain financial credibility with investors, especially international investors. Foreign investors are also beginning to question the credibility of the Federal Reserve and US Treasury. Foreign investors, including more than 60 global central banks, hold over $1,400 billion in securities of US agencies including Fannie Mae and Freddie Mac. Chinese investors alone own around $500 billion of GSE debt.

On July 23, 2008, the Financial Times, reported that the US embassy called the Kuwait Investment Authority, the world's sixth-biggest sovereign wealth fund, to reassure them about the "soundness" of bonds issued by Fannie Mae and Freddie Mac after Kuwait's minister of finance announced that the KIA was not planning to invest in their debt in future.

Pressure from key foreign investors forced the US government to act in order to ensure essential access to international capital. The actions, at best, stabilise the supply of mortgage credit in the US.

Future activity of the GSEs will be restricted, limiting supply of mortgage finance. Government support may help reduce the stubbornly high cost of mortgage finance, despite cuts totalling 3.25 per cent in the Federal Funds rate.

The proposals are not permanent. Withdrawal of support by future administrations and Congress, although unlikely, cannot be completely discounted. The $-100 billion commitment equates to less than 2 per cent of the $5.4-trillion GSE portfolio of mortgages and guarantees.

If existing capital (around $80 billion) is taken into account, this improves to around 3 per cent. Given rising default rates and the poor outlook of the housing market, the capital injection may not be sufficient to ensure solvency.

The GSE MBS investment portfolio (around $1.4 trillion which will modestly increase through to the end of 2009) will be gradually reduced after 2010 at the rate of 10 per cent per year to $250 billion each, or $500 billion total. The US Treasury assumes that the reduction in GSE portfolio size will be through natural run- off.

The Federal Reserve also holds MBS securities (over $400 billion) as collateral for loans to financial institutions under various liquidity support arrangements. The overhang of these securities may affect MBS prices and activity.

If credit conditions do not improve over the next 18 months, then the divestment of this portfolio may cause market dislocation, as the GSEs become users rather than suppliers of liquidity to the mortgage market.

Banks and insurers own a significant amount of the $36 billion in outstanding preferred stock in Fannie and Freddie. JP Morgan has warned of a possible $600-million loss on its $1.2-billion investment. Federal banking agencies believe that only a limited number of smaller institutions have holdings that are significant compared to their capital.

Given the fragile capital positions of many institutions, the losses create additional pressure to raise additional equity or reduce the size of balance sheets compounding the contraction of credit.

The problems at the GSEs indicate that the mortgage market generally, especially higher credit quality (prime and Alt A) mortgages, has deteriorated as the US economy slows, unemployment rises, availability of credit/ refinancing reduces and houses prices decline. The GSE rescue may presage further bank write-offs.

The banking system requires new capital. The government bailout comes after the failure of the search for a buyer or major equity investor to recapitalise the GSEs. The reluctance of the usual suspects - sovereign wealth funds and Chinese Banks - to act as the "sugar daddy" does not augur well for future capital raising by financial institutions.

The size of bailout and the ultimate cost to the US taxpayer is difficult to quantify. The commitment of the US treasury is $100 billion. This does not include funding under the secured credit facility.

The amount is unspecified but may be up to the $1.4-trillion MBS portfolio held by the GSE that can be pledged as collateral. When added to $400 billion of funding provided by the Federal Reserve to the financial system, the sums involved are not trivial.

There may also be other claims on the government. The FHLBs have expanded their lending and may need more capital. FDIC funding of around $45 billion may be inadequate to meet demands from bank failures, requiring additional government funding.

The US government's financial flexibility in meeting increased demands for funding is restricted as the budget deficit is already high and likely to worsen with falling tax revenues.

The GSE debt problem has been transformed into a US national debt problem. The US has total private debt of $4.7 trillion of which $2.4 trillion (51 per cent) is held by foreign investors. The GSE takeover adds around $5.4 trillion in debt and guarantees, of which around $1.4 trillion is owned by foreigners.

The increase may ultimately affect the ability of the US to finance its budget deficit and trade deficit. It may also affect the USA's AAA credit rating although the rating agencies have indicated that a re-rating is not eminent. A reassessment would threaten the status of the US dollar as the pre-eminent world major reserve currency.

A complete meltdown has been avoided temporarily. Equity markets and the US dollar rose sharply in response to the plan. The recovery in equity markets has not been sustained consistent with the reaction of the markets to previous government interventions over the last 18 months.

The GSE problems, Lehman's bankruptcy and the continuing problems at other financial institutions merely point to the fragility of the entire US financial system. They also highlight the limits of authorities in dealing with the problems. Like King Canute, they cannot hold back the tide.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall). At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.
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