The smell of ‘bailout’ is in the air. Like Pavlov’s dog, stocks are keying off the potential collapse of the nation’s two largest mortgage players who control about 75% of the market currently, looking for a bailout and subsequent rally. At any other time in history, this sort of event would have caused ripples through the financial markets. But in this new age of ‘moral hazard’ brought about by Heli-Ben’s easy checkbook in which bailouts are great for stocks, anything goes and is a buying opportunity.
What will Paulson do? That is the question. Does he throw the US Government, tax payer and Treasury Bond yields under the bus with an open-ended, retroactive bailout? A bailout designed to save the debt holders and/or the MBS holders such as China, Russia, Bill Gross and other rich investors who knew what they were buying? Does he throw the investors under the bus in favor of the US Government’s and tax payer’s balance sheets? Or, does he do a combination of both?
It is of little question whether Fannie and Freddie will have to be bailed out. Injecting capital into the firms and keeping them private is not an option because we are in the early innings of the housing and mortgage crisis and there simply is too much bad loan exposure. Remember, Fannie and Freddie have some $700 billion in subprime and Alt-A combined. Much of their Prime paper is many grades lower than originally rated due to faulty automated underwriting systems during the bubble years. So, how do they do it? Many, including myself, think that nationalizing these firms and running them like FHA going forward is the least painful for everyone. Granted FHA is a mess but somewhat predictable and not as large of a mess as the Agencies.
Arguably, the Agencies are making some of the best loans ever that should actually be profitable. Therefore, an ‘explicit’ guaranty going FORWARD would not be a horrible thing. With an explicit guaranty going forward and likely higher mortgage rates and spreads over Treasuries, investors should have no problem buying up the issues. They would be in such hot demand that it could conceivably make actual mortgage rates cheaper on the front end than they are today. This sounds great, right! Not so fast. The foreigners and rich investors want their bailout too.
It is not about how this will operate going forward so much as it is about the $5.2 TRILLION in debt and mortgage-backed debt outstanding that has everyone in a tizzy. The majority of outstanding Agency RMBS’s are owned by foreign governments such as China and Russia, investors such as PIMCO (Bill Gross), mutual funds, banks and pension funds. These are the smartest guys in the room and if they would have even glanced the way of an Agency RMBS prospectus, they would have seen it said this security is not backed by the US Government but rather the full faith and credit of two run-away, over-leveraged, quasi-Government, failing hedge funds.
Without an explicit RETROACTIVE bailout that saddles the US tax payer with $5.2 TRILLION in liability, people are worried that these players, especially foreigners, will quit buying US Treasuries. Well, that’s the risk you take. But at this point in time that is just speculation. Many of these investors have already significantly lightened their US Treasury exposure. Strangely enough, even more so around the time the news began to broke that the Government was considering retroactively backing $5.2 Trillion in Agency debt and RMBS’s.
What do you think happens to Treasuries if you do put the US at that great of a risk? US Treasuries will still get hit but by a much larger pupulation of owners and for a much longer period of time. If you saddle the US with an open ended, retroactive bailout of the Agencies for some of the worst loans ever made from 2002-2007, a disaster will ensue. We already know that GSE’s have significant subprime and Alt-A holding and much of their Prime paper is closer to Alt-A. Defaults are soaring across all paper types. Foreclosures could continue for years.
Just think about it for a minute. If we back all of this, much of it toxic, there is the chance that every time a negative piece of housing data comes out in the future, Treasuries could actually sell off vs. rally because that’s more bad paper that the US Gov’t must make good, guaranteeing payments to these investors. If we are in the early innings of this housing meltdown like many including myself think we are, then get ready for sky-high Bond yields because the only way to cover all of investors around the world will be through the sale of new Bonds.
We are in a ‘damned if we do and damned if we don’t’ situation. But, I see signs of hope. Take the New FHA Bailout law for example. It requires banks to significantly write down the value of their mortgage notes to 90% of the new value and get nothing in return. That is the investor sharing the responsibility.
The same thing should happen here. These wealthy, global investors knew what they were buying and taking a haircut on their Agency MBS holdings is not the end of the world. The US Gov’t and tax payer retroactively backing mortgage paper that never had a guaranty in the first place without any idea of when this housing and credit crisis will be over would do much long-term damage and force higher mortgage rates in the US and interest rates across the globe.
If we leave older vintage Agency securities to trade without a guaranty, investors would take losses because all older mortgage-backed debt has fallen in value given what has happened to the housing and credit markets over the past year and a half. But, these losses would not be massive and could be mitigated with ownership or warrants in the new and improved Fannie Mae and Freddie Mac that would be very valuable in the future, as the companies did well.
Activist hedge fund manager Bill Ackman talked about the bailout and a plan he has for the GSE’s. I like it. Below are the links. -Best, Mr Mortgage
Bill Ackman on Fannie/Freddie Bailout
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