Tuesday, September 9, 2008

The bailout of two GSEs is inevitable

• It has been two months since the Congress granted Treasury the authority to prop up Fannie Mae and Fredie Mac in July. Admittedly, it took bankers from Morgan Stanley to pore through the GSEs’ books and come up with workout plans. The Treasury thought its symbolic gesturing in July may move to calm the credit markets, with the hope being that Fannie and Freddie could still survive on their own without government intervention by rolling over senior debt and raising more capital, possibly in the equity markets if necessary. • Timing proved be to elusive, due in part to a deterioration in the overall economy and hence market situation and a lack of demand for agency debt. For example, with respect to the latter point, Asian central banks have recently trimmed their agency bond holdings. Though there is still some demand for the GSEs’ senior debt, the market views the cost as too expensive. The average spread of 3 month discount notes in 2008 was 66 bps, the highest level since 1999. • More importantly, the GSEs will face hundreds of billions of dollars in refinancing requests. For example, approximately $5 billion of discount notes matured in June, July and August for Fannie Mae, but for each of the following months of this year, an additional $50B of debt needs to be refinanced. Technically, Fannie Mae and Freddie Mac would have become insolvent by October or November if they could not refinance the debt due to mature in subsequent months. • In addition, the equity capital raising channel available to the GSEs all but evaporated, due to the uncertainty of the government bailout which resulted in a sharp price decline of the common equity price. • High premium spreads, large volume of refinancing requests, and lower interest of equity investors gave the Fannie and Freddie almost no chance to survive on their own, and the Treasury decided to take action this weekend.

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