|
Answer:
In our view, your investments in FNMA and FHLMC (GSE) debt and mortgage backed securities (not stock or preferred shares) are safe. We believe that an event of default by the GSEs is tantamount to a default by the US government. It could trigger, not just a US, but a global depression. The two companies own or guarantee about $5 trillion or nearly half of all U.S. home mortgage debt outstanding.
On Sunday, July 13, Treasury Secretary Henry Paulson sought authority from Congress to buy unlimited stakes in and lend to FNMA and FHLMC. Paulson proposed that Congress give the Treasury temporary authority (possibly for 18 months) to buy equity “if needed” in the companies, and to increase their lines of credit. In addition the Federal Reserve authorized the companies to borrow directly from the New York Fed. This plan of action is not immediate but can be put in place if needed. In other words, government aid is aimed at preventing the collapse of confidence in the GSEs.
From a regulatory capital perspective, the GSEs are adequately capitalized. FNMA, the healthier of the two, can sustain a 40% national decline in home prices and delinquency rates to increase 10-fold from current levels before it approaches its critical capital1 thresholds while FHLMC can sustain an approximate 5-fold increase of delinquency levels. FHLMC plans to sell $5.5 billion of equity after it reports earnings next month. Presently credit losses are projected at 17 basis points (bps) and 25 bps for 2008 and 2009 respectively.
The chart below shows the minimum capital requirements, core capital, and excess capital of the two companies2.
Critical capital is the sum of 1) 1.25% of balance sheet assets plus 2) 0.25% of off-balance-sheet obligations. Core Capital is the sum of:1) stated value of outstanding common stock; 2) stated value of perpetual preferred stock; 3) paid-in capital; and 4) retained earnings less Treasury stock. Minimum Capital is the sum of: 1) 2.5% of balance sheet assets; 2) 0.45% of outstanding MBS; and 3) 0.45% of other off-balance-sheet obligations.
So why all the worry? The comments about insolvency relate to the fair value of net assets (FVA), which entails marking the entire balance sheet to market (see chart above), similar to the NEV performed by credit unions. The irony is that our politicians encouraged the two due giants to take on more risk a few years ago when the first signs of subprime issues surfaced. Chuck Schumer, Chris Dodd and many others asked the GSEs to increase their leverage by buying non-agency mortgage securities to help the secondary markets. The market value of their balance sheets shows substantial unrealized losses due to these non-agency portfolios that they consented to buy along with lower values on the mortgages that they originated and held.
As discussed in an earlier article analyzing corporate credit unions, a negative fair value, in no way signifies that an institution will be unable to function as a going concern. Now, for some leveraged private funds that are marked to market every day, such as hedge funds, a negative FVA can be devastating, as it would almost certainly trigger margin calls from lenders and set in motion forced asset liquidations in a distressed market. However, for entities that buy-and-hold, a negative FVA does not necessarily hurt, unless confidence is severely eroded and, in turn, threatens access to funding. This is precisely why the government is taking steps to seek additional authority.
Without specific knowledge of the securities owned by the GSEs, it is hard to intelligently quantify what the extent of credit losses may be. As of March 31, 2008, 10% of the subprime securities for both GSEs were rated below investment grade. While this rating exists because the rating agencies clearly believe that losses are possible on 10% of the securities, it does not tell us whether the loss will be 0.1%, 1% or 10%. In other words, even the possibility of a de minimus loss can trigger a downgrade to below investment grade, which is a rating of below BBB .
FHLMC holds $207 billion of non-agency securities that they purchased from the secondary markets with an average market value of 85.80 cents on the dollar. The unrealized loss on these securities is $29.45 billion, again, just a fraction of which might ever be realized.
So what ultimately matters to the GSEs and all financial entities are access to funding. The GSEs have large liquidity portfolios, and over $1.5 trillion in unpledged assets3 which can be used to secure funding. Options provided by the government are nice to have; however, the most likely scenario is that the GSEs will indeed be able to raise capital from private investors. It would be interesting however to see the government buy stock in these companies.
3) Statement of OFHEO Director Jim Lockhart, July 10, 2008
|
