At the top of the critical list are Fannie Mae and Freddie Mac. The quasi-private mortgage agencies are in danger of being overwhelmed by losses on their holdings of mortgages and mortgage-backed securities (MBS). Ajay Rajadhyaksha of Barclays Capital estimates that Freddies balance-sheet has a negative value of at least $20 billion when marked at market prices; Fannie is $3 billion in the red. Both saw their share prices fall about 44% between August 18th and 20th as it appeared ever more likely that the government would intervene, wiping out existing shareholders. They are caught in a trap: the greater the risk of nationalisation, the harder it will be for the two institutions to persuade investors to provide an estimated $15 billion of new capital that each one needs if nationalisation is not to happen.
Loss of faith in the firms equity is one thing, ebbing confidence in their vast pile of debt is altogether scarier. Spreads on the $1.5 trillion of paper issued on their own behalf have widened. A five-year issue by Freddie on August 19th sold for 1.13 percentage points over treasury bonds, the highest spread for at least a decade. As recently as May, Freddie had found takers at 0.69 points over treasuries.
A sudden pullback by overseas investors is largely to blame. Foreigners, mostly Asian central banks and funds, hold 35-40% of the mortgage agencies total debt. They continued to be avid buyers this year, but their appetite waned in the first half of August (see chart), and was lower than normal in this weeks Freddie Mac auction. American money managers have taken up the slack, but they too are becoming twitchy about their exposure, according to a market participant.
The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. Chinas central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks. The spread on the securities has risen to around 2.2 percentage points over government bonds, even wider than it was during Marchs turmoil (after adjusting for todays lower volatility). This has helped to push up interest rates on the conforming mortgages that Fannie and Freddie buy or guarantee, at a time when private finance has slowed to a trickle.
The banks that manage the agencies debt issues are pulling out all the stops to ensure their successeven to the point of artificially boosting demand through deals known as switches. In such an arrangement, an investor agrees to buy into a new issue in return for being able to sell back to the banks an equal amount of an old one, thus ensuring its net exposure does not rise. If enough of these deals are struck, large amounts of debt can be shifted even when demand is thin. A recent $3.5 billion issue by Fannie was helped along by very significant amounts of switching, says one banker. With $223 billion, or one-seventh, of the agencies debt falling due before the end of September, those peddling it will have their work cut outespecially if the Asian investors continue to be put off by unkind headlines.
This is not what Hank Paulson, Americas treasury secretary, envisaged last month when he announced an emergency plan to rescue the twins. By pledging to invest in them if needed, he had hoped to calm markets and thus reduce the likelihood of a bail-out. That gamble looks ever less likely to pay off, however.
If a government recapitalisation does prove necessary, the treasury is likely to take one of two routes: a preferred-stock investment that allows the agencies to raise more capital of their own, or nationalisation through a common-equity injection that leaves current owners with nothing, and thus offers the taxpayer a better deal. Jeffrey Lacker, head of the Richmond Federal Reserve, this week threw his weight behind the second option. Nationalisation would probably also lead to the removal of both institutions managements, and undermine the cosy ties the agencies have long had with Congress.
This comes against an increasingly bleak backdrop. Lehman Brothers, the smallest of the four remaining full-service investment banks, is still struggling to persuade the stockmarket, and its clients, that it has a future. Faced with another big quarterly loss, it is hawking around both its worst assets (a toxic commercial-mortgage portfolio) and its best (Neuberger Berman, a fund manager). Selling a chunk of Neuberger would raise much-needed funds, but it would also leave Lehman looking far less diversified and less stable.
This week Goldman Sachs, the only investment bank still in decent shape, cut profit forecasts for all of its main capital-market rivals, including Lehman, citing the need for further write-downs and a drought in key business lines. (Some analysts had cut their Goldman forecasts the week before.) It also released a scathing report on American International Group, putting its losses from mortgage-related swaps at up to $20 billion, and even suggesting the giant insurer could suffer an impairment of counterparty confidence. The spreads at which big banks lend to each other hit a two-month high. One of them may go bust in coming months, mused Kenneth Rogoff, the IMFs former chief economist, one of a long list of those who think the worst is yet to come. Given what has already been endured, that is a blood-curdling thought.
The Economist Newspaper Limited 2008