Get the bazooka ready

July 10, 2009


(Corrects paragraph 9 to read “$1.25 trillion of mortgage bonds” instead of “$1.25 billion”.)

It has been almost a year since Hank Paulson asked Congress to give him a bazooka so he could show markets who’s boss. Instead, it was the markets that put the former Treasury Secretary in his place, and they still look very much in control.

That’s going to make an exit from one of the most distorted corners of the U.S. credit markets extremely difficult, if not impossible, when much of the government’s support built into mortgage-backed securities and agency debt is set to expire at the end of the year. Maybe that’s why no one is talking about it and bond investors are left to guess what the next step may be.

And it’s a cautionary tale for the Obama Administration about the perils of throwing buckets of money at a problem without a long-term plan as it considers what to do over the next few months.

The bazooka of course refers to the firepower that Congress gave the U.S. Treasury so it could swoop in and support the once powerful housing giants Fannie Mae and Freddie Mac. Paulson hoped never to use it, but markets called his bluff and by September, the government pulled it out, blasted away and put the two companies into conservatorship — a kind of halfway house for wayward companies that falls short of outright nationalization.

Since then, the companies have drawn $85 billion of the combined $400 billion senior preferred equity line offered so they could offset losses, but it’s the government’s huge intervention in the credit markets that will make an eventual disentanglement extremely difficult and push it back further down the road. In fact, the bazooka may need to be reloaded.

That’s because of Fannie’s and Freddie’s dominance in the home finance business and its role in propping up a housing market that could take another turn for the worse as the unemployment rate ticks higher.

The companies, rather than extending financing directly to homeowners, guarantee pools of qualifying mortgages that are packaged into tradable bonds. Since the onslaught of the credit crisis, Fannie and Freddie and the $4.5 trillion market for the bonds they guarantee are pretty much the only game in town when it comes to keeping financing flowing to the housing market.

And this is what gives the markets the upper hand. To keep the lending machine humming, the government has poured nearly $900 billion into the mortgage-backed securities market and to a much lesser extent the debt market where Fannie and Freddie raise money to finance their operations. Just to put this number in perspective, it’s more than 22 times the amount pledged to suck toxic assets out of the financial system announced this week. And the government isn’t done yet.

The Federal Reserve has pledged to buy as much as $1.25 trillion of mortgage bonds that Fannie and Freddie guarantee as it tries to keep a lid on the rates on home loans. It already has little more than half of that. It’s also potentially on the hook for a total of $200 billion of debt issued by the two companies and has already snapped up $97 billion of that. The U.S. Treasury, meanwhile, has bought $161 billion of mortgage-backed securities since the companies were put in conservatorship.

In addition, the two companies, most notably Freddie, have increased their own purchases of these mortgage bonds.

This support is scheduled to expire by the end of the year — including the Fannie and Freddie purchases, since the conservatorship requires the two companies to start shrinking their investment portfolios by 10 percent a year.

This is important for a couple of reasons. One, these purchases have been key in keeping mortgage rates low enough so homeowners in trouble can get more affordable financing and potential new buyers can better afford a home. The 30-year fixed rate mortgage rate currently sits at 5.2 percent, which while up from the lows hit earlier this year, is well below the 6.37 percent seen this time last year.

And two, the purchases have also distorted the credit markets, particularly the mortgage-backed securities market, beyond recognition, raising the possibility of sharply higher mortgage rates. The government’s purchases, which represent more than a quarter of the total market, have more than made up for the abrupt exit of foreign investors last summer, but those investors still haven’t returned even with such overt government support of the market.

The purchases have also pushed aside many domestic investors who have been forced to look elsewhere, including sliced and diced repackaged mortgages, to make sure they can still book attractive returns.

This is going to make an exit from this market one of the last the government undertakes. Given the outlook for housing, Treasury and the Fed should start warming up the bazooka for next year.


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