Fannie Mae and Freddie Mac... Part II

Deidra Krys-Rusoff is a member of our fixed income team at Ferguson Wellman Capital Management, specializing in all aspects of fixed income trading for the firm. Prior to joining us in 2004, Krys-Rusoff was an institutional portfolio manager for a large regional bank.

In a weekend move reminiscent of the Bear Stearns bailout, the federal government made the move on Sunday to explicitly provide a federal guarantee for both the senior and subordinated debt of Fannie Mae and Freddie Mac by taking both entities into conservatorship.  

What is the structure?
The U.S. Treasury, Federal Reserve and the Federal Housing Finance Agency seized control of Fannie Mae and Freddie Mac. They suspended dividend payments to common and preferred shareholders and introduced several new programs including: a capital injection of $100 billion for each agency in the form of “preferred stock;” the establishment of a credit facility to provide short-term funding for both entities; limited portfolio growth; and the initiation of a mortgage-backed securities buying program. These programs were established under the authority granted by Congress in July, which will expire in December of 2009. At that time, the next administration and Congress will be responsible for deciding whether to extend, change or eliminate the aforementioned programs.  

Markets’ reaction?
In our communication to clients on July 17, we reiterated that agency debt was essentially federally backed and we were therefore “comfortable holding agency bonds in our clients’ portfolios.” As of yesterday, explicit government backing became fact and the senior and subordinated agency debt offerings of both entities rallied. Since Friday’s close, yields have dropped between 30 and 50 basis points on the senior debt and over 100 basis points on the subordinated debt. The common and preferred stock dividends of both Fannie Mae and Freddie Mac were immediately eliminated; but both equities will continue to trade, albeit at distressed levels. It is possible that both of these agencies may emerge from conservatorship to be privatized again in the future, but the outlook for equity investors is quite bleak.  

What does this bailout mean for the housing and credit markets?
In the short term, mortgage rates may move modestly lower, by a quarter to a half percent, and Fannie Mae and Freddie Mac will likely lower some of their guaranty fees. Agency debt and government mortgage-backed securities will continue to strengthen due to the explicit government backing and additional liquidity we expect the new programs to provide. Treasury prices may fall (slightly) as the U.S. Treasury takes on these additional financial responsibilities.

Bottom line?
Even though interest rates may fall slightly and modestly help housing, it’s the lack of liquidity rather than high mortgage rates that have been fueling the housing crisis. While this government intervention certainly assures the solvency of Fannie Mae and Freddie Mac debt, this does not necessarily signal a turning point for U.S. home prices, for the U.S. economy, for the equity market, or for the availability of credit … these all remain a work-in-progress.