USA: RGE MONITOR, FANNIE&FRED, ROUBINI

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Neither immediate access to the central bank liquidity, nor an expected large increase in credit lines from $2.25bn each, nor the prospect of recapitalization – effectively a public bailout plan - were able to calm markets about the financial health of FannieMae and FreddieMac, the government-sponsored enterprises (GSE) that own or guarantee $5.3 trillion in mostly prime mortgages. Agency bond spreads widened again and the share prices tumbled further after Moody’s downgraded the GSEs preferred stock and financial strength rating, helping to spread selling pressure on commercial banks and brokers. In order to restore some calm in the markets, the SEC had to step in by putting a limit on short sales of GSE and broker dealer stocks in a move reminiscent of an earlier emergency intervention by the UK FSA. Follow the latest developments in: Despite Liquidity Access, Equity Stake, And Credit Line: Moody's Cuts Fannie's and Freddie's Preferred Stock Rating

By accounting for 80% of all RMBS issuance in Q1 2008 after the private-label issuance practically dried up, the GSEs now are “the” mortgage market. Ignoring their fate or carrying on as before is not an option. In the longer run the main alternatives emerging are threefold: First, full government guarantee on both the $1.6T investment portfolio financed by agency debt and the $3.7T guaranteed off-balance sheet ‘pass-through’ business line. This seems effectively to be the favored version of the U.S. Treasury so far. Second, an explicit government guaranty on the pass-through business, but a restructuring and compression of the highly leveraged investment portfolio by letting agency debt holders take a haircut. The third option is no bail-out at all but a restructuring of the entire $5.3T GSE debt, including a reduction in the face value of the debt by maybe 5% (given the high quality of assets). Or, if leaving the face value intact, the interest rate GSE debt holders receive should not exceed the Treasury bond yield – by now agency debt holders enjoy a yearly subsidy of $50bn in the form of agency bond spreads over Treasuries (100bp on $5.3T is $50bn.). Read about the wide range of proposals by our many contributors to the RGE Finance&Markets Blog

Far from being a purely domestic issue, much of Fannie and Freddie’s debt is held by foreign investors, especially Asian central banks and big Japanese banks, many of which have increased their holdings of U.S. agency debt given its higher yield over Treasuries. The U.S. bailout means that their trust in the government’s implicit guarantee of the GSEs has been rewarded, but will terms be different in the future? And if the agencies debts are called into question, what effect will it have on central banks purchases of U.S. debt? See Will Foreign Governments Keep Buying U.S. Agency Bonds?

The GSEs are not the only ones hitting a rough patch. After the run on the Alt-A lender IndyMac, investors are taking a hard look at regional and commercial banks’ balance sheets and they don’t like what they see. High construction loan and commercial real estate exposures, low coverage ratios and very difficult financing conditions are darkening the solvency outlook for many highly exposed banks fast. OCC Director John Dugan was very frank in his assessment of the situation in January when he warned of many more bank failures to come. In a downturn similar to the late 1980s/early 1990s, the number of failures could reach 300 according to analysts. Read more in: “Bleak Earnings Outlook, No Access To Equity Capital: How Safe Are U.S. Regional Banks?”

Investment banks are also back in the spotlight again. The CDS spread on Lehman debt is back above 400bp, just short of its 450bp peak when Bear Stearns collapsed. A stand-alone survival seems ever farther away and a white knight is still missing. Are policymakers prepared for another potential collapse of a major broker dealer? Secretary Paulson warns in recent speeches that, different from Bear Stearns, the next institution too-big-to-fail might be required to file for bankruptcy in return for government support.