As a parent, one would not reward a child with extra dessert for throwing his dinner against the wall.  As a boss, one would not lavishly remunerate an employee who has negligently cost the company money.  Poor behavior should be punished, or at the very least, not encouraged.

Unfortunately, Uncle Sam continuously insists on not only rewarding, but actually encouraging bad behavior on the part of consumer borrowers.  The Lamb has been a vocal critic of the American Mortgagor as the prime suspect in the current financial impasse.  While others certainly share the mantle of culpability, the American homebuyer stands atop the pedestal of guilt.  His inability/unwillingness to repay debts he assumed voluntarily is at the crux of the current crisis.

So, what should be done?  Well, what should NOT be done is what the Treasury is currently considering.  From The Wall Street Journal:

“The plan, which is in the development stages, would use mortgage giants Fannie Mae and Freddie Mac to bring loan rates down as low as 4.5%, a full percentage point lower than the prevailing rates for 30-year fixed mortgages.”

Let’s see.  Easy credit over the past few years encouraged borrowers to take on more debt than they could afford to pay back.  This led to a wave of defaults, causing lenders to go bankrupt, which threatened to destabilize the financial system.  This led to bailout after bailout, which coincided with historic downdrafts in asset prices in everything from equities to commodities, and from high-yield debt to Triple-A asset-backed securities.

Now that asset prices are beginning to show signs of stabilizing, what should the next step be?  Hmmm… that’s a tough question…  Wait!!!  Why don’t we use artificial means to make credit easy again?  Yes, that’s a great idea!  In fact, let’s just go ahead and use taxpayer money (which, by definition, is money paid by those who acted prudently by NOT borrowing over their heads and are still paying taxes) to encourage even further bad behavior (i.e. — more borrowing).

In fact, that is exactly what is being proposed (again, via The WSJ):

“Under the plan, Treasury would buy securities underpinning loans guaranteed by the two mortgage giants, which are temporarily under the control of the government, as well as those guaranteed by the Federal Housing Administration.”

Already, the New York Fed is planning on purchasing Fannie and Freddie (GSE) debt.  The first purchases are slated for this Friday.  From the New York Fed’s website:

“What is the policy objective of the Federal Reserve’s program to purchase direct obligations of the housing-related GSEs?
The goal of these debt purchases, combined with the purchases of mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac and Ginnie Mae announced on November 25, 2008, is to reduce the cost and increase the availability of credit for the purchase of houses.”

Sounds like giving your kid more messy food to throw against the wall.

When is a guarantee not a guarantee?  Well, the United States federal government would like you to believe that the answer is “never.”  When the feds say that certain debt is guaranteed, they would like the global investing public to have no fear, to suspend any fancy security analysis they might be tempted to undertake, to just close their collective eyes and “wave ‘em in.”

Unfortunately, the law of unintended consequences is a tricky thing.  Last month, Uncle Sam essentially turned what had been an implicit backing of Fannie Mae and Freddie Mac (GSEs) senior debt into an explicit one (see the post Fannie, Freddie, and Sam).  The Lamb is almost always against government interference in the operation of free markets.  However, he applauded this move in part because the feds had done almost nothing over the decades to disabuse the public of this implicit backing and because the consequences would have been catastrophic.

Following the GSE “bailout,” the feds turned to Corporate America and decided to effectively insure the continued steady issuance/financing in the commercial paper market.  Not done razing the bastion of capitalism, the government last week sought to guarantee certain senior unsecured bank debt.  Enter FDIC Chairman Sheila Bair:

The [FDIC now] guarantees new, senior unsecured debt issued by any bank, thrift or holding company, which will help banks fund their operations. Both term and overnight funding of banks has come under extreme pressure, with the costs of funding ballooning to several hundred basis points.

This guarantee will allow banks and their holding companies to roll maturing senior debt into new issues fully backed by the FDIC. However, guaranteed maturities cannot extend beyond three years. The ability to tap into this program expires at the end of June 2009.

The FDIC guarantee is not exactly like having the full faith and credit guarantee of the United States government (this is fodder for another post), but it will have the same deleterious effect on certain parts of the capital markets.  As more and more types of debt are guaranteed, the relative value of that guarantee diminishes.

Let’s venture back to the effectively “full” guarantee of the GSEs.  Prior to this event early last month, GSE asset-swap spreads (the yield differential between GSE debt and the swaps curve) were trading near their highest level ever, almost even with the swaps curve (i.e. – costing the GSEs more than ever to borrow money). 

After the GSE guarantee was announced, these spreads decreased dramatically, hitting all-time low levels of around fifty basis points lower in yield than swaps (i.e. – making it cheaper than ever to borrow money). 

However, following last week’s bank debt guarantee proclamation, these spreads rocketed higher.  By Friday, the GSEs’ funding costs had reached all-time high levels of thirty bps higher in yield than swaps, making it incredibly expensive for the GSEs to fulfill their newly assigned duties and costing taxpayers more money.

Think about how incredible this is.  These spreads usually move just one or two basis points per week, with a long run average of around 20 basis points lower than swap rates.  Yet, in the course of less than two months, the GSEs’ relative funding costs have gone from average levels to all-time low levels to all-time high levels!

GSEs Relative Cost of Funding

What are the GSEs’ duties and why do we care?  Good questions.  Answers:  around a week ago, federal regulators ordered Fannie and Freddie to purchase $40 billion of distressed mortgage-backed securities every month, in addition to their regular purchases.  The more expensive it becomes for Fannie/Freddie to finance these purchases, the more it ultimately costs taxpayers. 

Regardless of your opinion of the wisdom of these purchases, the devaluation of the “sacred” federal government guarantee has caused a kind of self-defeating paradox.  Guaranteeing all has become worse than guaranteeing none.  Since bank debt has always traded at higher yields than GSE debt, investors who seek out this guarantee will now eschew GSE debt in favor of bank debt.  And why not?  They’ll be buying debt with essentially the same ultimate credit (the United States Government), but be gaining incremental yield for free!

Uncle Sam is fighting himself and the American taxpayer will be the big loser.

"Which Bonds?" Indeed

In a move cheered by some and condemned by others, Uncle Sam over the weekend adopted his petulant niece and nephew, Fannie and Freddie, essentially making his longstanding implicit guarantee of their senior debt obligations now an explicit one.  The Lamb is generally against government interference in the capital markets.  However, there existed the oft-quoted systemic risk that if Fannie and Freddie continued to misbehave, others could be irreparably harmed.
 
Who are these “others”?  Well for starters, dear reader, one of them is you.  “Me?” you ask?  “But I don’t own any Fannie or Freddie debt,” you protest.  Well, while that may be technically true, chances are that the municipality to whom you pay property taxes, and the state to whom you pay income taxes (unless you live in a state like Florida or Texas) does own this debt.  Were Fannie and Freddie to go “toes up,” to whom do you think these local and state governments would come calling on to make up the shortfall?  You need only look in the mirror for that answer.
 
Now, let’s look at what some consider to be one of the safest investments available– money market funds.  Many if not most of these funds, which total some $3 trillion dollars, have as a core asset Fannie and Freddie paper in the form of discount notes or short-dated medium-term notes.  These had been purchased as a “safe” surrogate to U.S. Treasuries that came with the convenient feature of a yield kicker, in some cases as much as 100 basis points for similar maturities.  Were Fannie and Freddie to fade away, many of these funds would “break the buck” without their parent buying back these now-impaired assets at face value.  A cascade of failures in this investment area would all but freeze short-term funding for most global financial institutions.
 
Finally, but certainly not least, are foreign central banks.  Countries and sovereign wealth funds from China to Russia, and from ADIA (The Abu Dhabi Investment Authority) to the MAS (The Monetary Authority of Singapore) have bought hundreds of billions of dollars worth of Fannie and Freddie debt.  If they believed that this paper was somehow not “money good” and began to dump it en masse, the effect on domestic interest rates and on the dollar itself could be disastrous.  If this lack of confidence began to trickle into their holdings of U.S. Treasuries, the ramifications could be calamitous.
 
As distasteful as it is, Uncle Sam had no choice but to place Fannie and Freddie under conservatorship.  His treatment of their toys (e.g. the Preferred Stock and Subordinated Debt) can be debated, but the Senior Debt had to be protected.