Update: 9:40am EDT, 14Jul08: Overseas markets reacted well to the Paulson "we have a plan" statement. Asian markets ended lower on regional concerns while Euro markets are somewhat higher. The US stock market has opened up over 100 points, while the US Treasury market is only slightly lower. FNM and FRE stock were both up about 20% in pre-market trading, while their bonds, swaps, and CDS are all considerably tighter but not as tight as earlier this morning. Good initial reaction. We'll see what the follow-through is. [End of update]
A lot of people heaved a big sigh of relief when the financial markets finally closed on Friday afternoon, including myself. It was one of those hair-raising weeks in which major financial institutions, not only systemically important but also widely deemed basically healthy, tottered and wobbled.
Of course I’m talking about Fannie Mae and Freddie Mac, the huge government-sponsored entities (GSEs) that together buy or back up nearly half of all the residential mortgages in the US.
It’s déjà vu all over again for Wall Streeters. This feels a lot like the weekend that the Bear Stearns Companies were put to death, back in mid-March.
And all through that wild weekend, officials at the New York Fed, the Federal Reserve and the Treasury Department worked frantically around the clock to resolve the situation before trading opened in Asian markets. That is, by Sunday evening, New York time.
Everyone expected that Treasury Secretary Henry Paulson would be burning up the phone lines this weekend too, and he did. A few moments ago, he issued this terse statement. It lays out an expectation for a range of actions by the Treasury Department and the Fed to ensure the continued smooth operation of Fannie and Freddie when the markets re-open for trading a few minutes from now.
There’s no time right now to give you a full analysis of the GSE situation. That will have to wait until the dust settles. The most crucial thing to watch at this moment is how markets react to Paulson’s statement in Asia, in London about nine hours from now, and in New York tomorrow morning.
If markets react well, you could see an explosive relief rally, perhaps hundreds of points in the stock market. If they dont react well... something else will happen.
The issue with Fannie and Freddie is concerns about their capital adequacy. There is a lot of concern that rising delinquency and foreclosure rates among the prime, highly-safe mortgages that the GSEs underwrite and fund will squeeze their profits. That causes their stock prices to fall. And that in turn raises concerns that they may have trouble borrowing the investor funds that then go into home mortgages.
I have a great deal more to say on this matter, but time is short. For now, please hear and internalize this:
Fannie Mae and Freddie Mac are not in danger of going out of business.
Some extremely immoderate fears have been flying around, most of them unfounded. But as we saw with Bear Stearns in March, reality isn’t the first thing people look at when everyone is panicking.
The situation is extremely fluid and potentially very dangerous.
There is a lot missing from Secretary Paulson’s statement. He raises the possibility of immediately extending and expanding credit available to Fannie and Freddie directly from Treasury. There’s also talk of having Treasury directly purchase equity in the GSEs, which would immediately end their status as semi-private entities.
But all of this would presumably need to be done in cooperation with Congress, which has recently gotten very sticky about letting the Treasury and the Fed operate with a free hand in this time of crisis. Hopefully we’ll know very soon whether Congress will step up to the plate and move fast. I believe they will.
And what about the operational plan that would be most palatable to free-market conservatives? Namely, stand back and let the market do its worst?
That really is not an option at this point in time. The world of finance is a fully-meshed, continuously integrated global system. It’s not only possible, but entirely credible that a major stress involving Fannie and Freddie would have dire repercussions.
As I said, the problem is not that the debt securities floated by the GSEs are worthless. That couldn’t be farther from the truth. The problem is that the world is looking for an assurance that the securities will continue to be in demand at stable valuations. Without that assurance, they may start readjusting their portfolios in... (ahem) disruptive ways.
As Paulson said, we’re talking about $1.2 trillion worth of debt, and it’s in almost every large portfolio in the world. That’s a lot of people who need to be reassured.
It almost doesn’t matter how you reassure them. If we have to make an explicit guarantee that the taxpayers will back the debt up, so be it.
And we hold our breath. More news as it develops.