Who’s afraid of the GSEs?

A middle-aged couple inviting their unsuspecting guests to partake in the escalating unraveling of their existential crisis. Not quite Edward Albee, but the story of Fannie and Freddie certainly has the right ingredients for the playwright’s next Tony award winner.

Terrifying, to start with, judging from the successive stampedes on the companies’ stock prices as recently as last week, and the emergency measures by the Fed and the Treasury over the weekend. So…. who’s afraid of the GSEs?

With the introductions to Fannie and Freddie already made (see "Fannie Times"), let’s go straight to Act Two: “Portrait of a GSE drowning." /1

The capitalists: Fannie and Freddie’s shareholders have just had their “Snap!” moment: They woke up to the fact that the capital they put into the two GSEs (or “Government Sponsored Enterprises”) may be close to annihilation. Not that this was any news, but the fact that a former Federal Reserve bank president uttered the words “insolvent” and “GSEs” in the same sentence was probably the equivalent of throwing a bucket of cold water on their lethargic faces.

Ben and Hank didn’t help when, during their Congressional testimony on Thursday, they “confirmed” the adequacy of the GSE’s regulatory capital with resounding unease. Neither did the not-so-distant memory of Bear Stearns’ collapse, which hinted that the government’s “sponsorship” might not reach as far as saving the capitalists. The result was a panicked sell-off of Fannie and Freddie shares that brought their prices to their lowest in 17 years. But, no worries, it only hurts if you’re a shareholder.

The lenders: The GSEs’ lenders are also getting edgy. These are holders Fannie and Freddie debt, which stood at 1.6 trillion dollars at the end of March. GSE debt has been attractive to investors, as it pays a higher yield than US Treasuries despite the perception that GSEs are just as safe as the US government—the (not so unreasonable) presumption being that the government would step in to bail them out if trouble hit.

So who are these presumptuous “dupes”? To begin with, foreigners, such as Japanese pension funds or the Chinese central bank. Ha, I can see that wry smile on your face, but don’t let it become too visible. Even Chinese bureaucrats and Japanese grandmas have heard of the word “Sell”. Importantly, the bulk of Fannie and Freddie debt is still held by domestic investors, from commercial banks to pension funds to hedge funds. Any piece of news that would hint to the GSE’s inability to pay would spark substantial losses across the financial system.

The MBS holders: On top of GSE bonds, the commercial and investment banks, hedge funds and Japanese granmas loaded themselves with mortgage-backed securities (or MBS) guaranteed by Fannie and Freddie—$3.7 billion worth of those. Now, in “normal” times these MBS are considered very safe thanks to the GSE (read “implicit US government”) guarantee. But what happens when things go “abnormal”?

March 2008 is a telling example. The “normal” difference between the yields of Fannie MBS and US Treasuries had been just above 1 percent. In March this jumped to more that 3.5 percent, as the generalized loss of confidence reached the GSE sphere. Higher yields means lower price and, in the process, a few spectacular casualties emerged, including hedge funds who had placed the bulk of their (27-times-leveraged) bets on the safety of GSE MBS and, ultimately, Bear Stearns.

The dealers: These are the counterparties of Fannie and Freddie in the derivatives market and they have good reasons to be nervous. Fannie and Freddie are big players in this market because they use instruments like options or interest rate swaps to better match the profile of their debt payments with that of their income stream. The sheer size of their participation means that, if one of them were to fail, dealers would be left with a fat hole in their books corresponding to the payments due by the failed GSE.

The Fed: Just as Ben dared his first sigh of relief that “downside risks to growth have diminished somewhat”, Fannie and Freddie rushed in shouting “not yet!” So long as their capital remains thin and fragile (actually negative, if you live in “fair value” universe), the Fed feels the pressure from all directions: Head on is the possibility of a run on Freddie, if investors panic and transform a (temporary?) solvency problem into a full-blown liquidity crisis. A Bear Stearns encore, only bigger!

Coming on from the sides is the ongoing housing crisis: Collapsing house prices and rising delinquencies promise even more losses for Freddie and Fannie and an ever “thinner” capital. Finally, you have the Fed’s own monetary policy dilemma—the spike in inflation expectations and cost pressures from high commodity prices might have commanded an increase in interest rates; yet the downside risks to growth are tying the Fed’s hands, and Fannie and Freddie are at the forefront of the tying “operation.”

Act Three: Capitulation. It’s ironic that the purpose of the GSE’s establishment—to promote risk-sharing and stability in mortgage markets—is now being undermined by the GSEs themselves. It’s even more ironic that, with their capital already thin and thinning, Congress summoned Fannie and Freddie earlier this year to become “MBS buyers of last resort.” That is, take on more mortgage risk, at a time when nobody else was prepared to do so, with the hope of providing a hint of life support to home prices.

Without wanting to sound like a yoga-mat & tofu moralizer, “stability should begin from within.” Can’t have the GSEs take on more mortgage if that exposes their capital (and those around them) to a blow up. Unless of course you are prepared to bail them out…

Speaking of which... Earlier today, the Fed said it would allow Fannie and Freddie to borrow from its window, while the Treasury asked Congress for authority to buy unlimited stakes in the two companies, if needed. Steps that have finally made it crystal clear that there is one and only group of people who should be afraid of the GSEs… the American taxpayers.


Glossary: Government sponsored enterprise, mortgage-backed securities, systemic risk, Edward Albee, capitulation.

1 The title is a paraphrase of a quote in Albee’s “Who’s afraid of Virginia Woolf” when Martha refers to her husband George as “Portrait of a man drowning.”