BID® Daily Newsletter
Jul 14, 2008

BID® Daily Newsletter

Jul 14, 2008

FANNIE MAE AND FREDDIE MAC


Over the past 3 days, we found out that FNMA and FHLMC are indeed, "too big to fail." The Fed and the U.S. Treasury worked the weekend and announced a plan last night (to be approved by Congress) to provide additional liquidity and the temporary ability to purchase equity in either company "as needed." Market players did the math on Friday and realized that both FNMA and FHLMC (with a combined $1.6T of debt outstanding and a guarantee for over $4T of mortgages) now have a major negative mark-to-market position. This not only creates problems for accounting, but both entities will need another $10B in capital to shore up reserves at a minimum (and probably triple that if the economy gets worse).
Whether Gov't lending takes place via the Discount Window or through a new facility - it doesn't much matter. It also matters little if the Fed increases its mere $2.25B guarantee in both companies or just goes ahead and makes an equity infusion. At this point, it is also not worth the debate (it will be later) over how the "moral hazard" of shoring up failing companies creates other risk. The biggest point here is that for the 2nd time in past 4 months, the U.S. financial markets have come precariously close to a debilitating shock.
In the coming weeks, there is little doubt that the greatest effects from the Fannie and Freddie problem will be a further deterioration of global financial confidence in the U.S. This means a continued weak dollar, higher rates on Treasury and Agency obligations and less global liquidity.
The other immediate takeaways are that the U.S. Treasury still thinks that the GSEs should exist going forward "in their current form, as shareholder-owned companies." It also appears that the Gov't does not intend to ask FNMA or FHLMC to decrease the current size of their portfolios (which would help bank asset prices).
For bank balance sheets, their price on GSE bond investment holdings remained stable. Spreads decreased some 14bp, as the market assumed a full Gov't guarantee, but yields increased 20bp. Immediately, banks should access their exposure to both GSEs and increase their risk monitoring. Should the Gov't support package come to fruition, the move would result in an excellent opportunity for banks to purchase both FNMA and FHLMC mortgages, as they would improve in price, probably similar to where GNMA mortgages trade.
However, these items are all relatively minor to the big picture for banks. The number one tactic that community banks must employ right now is to increase marketing to make sure depositors and investors are aware of bank financial stability and FDIC insurance guarantees. The increased headline risk of FNMA and FHLMC could call into question the stability of the U.S. banking system and raises questions across the board. This effect is made even greater, considering that this week marks the start of 2Q bank earnings releases which are expected to be poor.
Bad news stories such as the one the WSJ ran today on IndyMac (saying that depositors "in general,...will eventually get 70% to 80% of their funds returned") will create additional deposit run off and make it harder for banks to raise capital.
In addition, there will likely be additional volatility around Fed Chair Ben Bernanke's semi-annual Humphrey Hawkins testimony next Tuesday (Chair Cox from the SEC is also being called to testify in this forum for the 1st time in history). Given the recent events, we look for Bernanke to be more dovish, thereby flattening the interest rate curve (shifting rates down).
More volatility and uncertainty is ahead and it pays for community bank CEOs to increase risk management and communication with employees, shareholders and customers, in order to mitigate some of the risk.
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