Too Big To Fail!

By: Robert Ohanesian and Nick Burwell

Almost a year has passed since news of the credit crisis began to take center stage. Unfortunately, we must now sift through the complex predicament of Fannie Mae and Freddie Mac. When analyzing these mortgage giants and the implications for the financial markets posed by their current and future state of affairs it is crucial that we ask ourselves the right questions.

The first question, and arguably the most important, is whether or not the United States Government would ever let either of these enterprises fail. The answer is simply, no. These organizations were created in order to promote home ownership in this country and no politician wants to be perceived as unsupportive when it comes to this issue. The second question we must consider is whether our government will have to go so far as to take over or "nationalize" either of these institutions. It seems clear that this outcome is absolutely the option of last resort and we could only envision this scenario playing out if housing prices continue to fall significantly further. At this time the Treasury Department has said it will seek congressional approval to significantly increase the agencies lines of credit. The Treasury is also seeking authority to potentially purchase equity in either company if needed. The Federal Reserve has also pledged to temporarily open up the discount window to the agencies just as it has done for the brokerage houses.

How did Fannie Mae and Freddie Mac reach the point were they currently own or guarantee roughly half of the $12 Trillion of our countries outstanding mortgages? The answer can be given in one word, leverage. Because government-sponsored enterprises can issue debt that is interpreted by investors as implicitly guaranteed be that U.S. government, and by default the U.S. taxpayer, they can borrow money in the fixed income markets at rates a bit higher than the U.S. Treasury but lower than corporations. The two agencies combined own or guarantee roughly $5 trillion in mortgage assets, approximately half the U.S. market. They also carry quite a lot of outstanding debt, roughly $1.5 trillion. What we believe is key to the current predicament of Fannie and Freddie is that it is not enough for the two enterprises to exist just in order to meet its existing obligations. In order for the U.S. housing market to avoid a near total freeze Fannie and Freddie must continue to be able to borrow at below market rates. The market for new mortgage-backed securities is now almost entirely made up of agency-backed securities. There will be a cost for continued subsidized interest rates and that cost will inevitably make its way back to the U.S. taxpayer. We view it as highly likely that this cost will manifest itself in the form of more Treasury supply coming to the market and as a result higher yields for Treasury securities.

The only scenario in which we could justify an overweighting of Treasury securities relative to agency paper would be if we believed that these institutions would be left to fend for themselves. Again, we do not view this as a likely scenario. If the government were to nationalize these institutions their current debt and any new debt issued would trade even tighter to Treasury securities. We estimate that the agencies will continue to exist in their current form, enjoying lower borrowing costs due to the liquidity backstop provided by the U.S. government in any and all forms it can think of short of a complete takeover.

We will continue to accent yield as a risk reducing strategy as well as seek out relative value opportunities in the high-grade lower duration corporate sector. We will continue to follow the government sponsored enterprises closely, specifically their capital levels and the performance of their loan portfolios. We will continue to look at the health and stability of these institutions for clues regarding the state of the housing market as well as any implications for future trends in interest rates.