Fannie & Freddie January 3, 2010, Peter Demirali, Vice President & Portfolio Manager
Last year’s economic and market free fall really got underway as it became apparent that the two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, posed a systemic risk to the financial system. Over the years, hundreds of billions of dollars worth of bonds were sold to domestic banks and foreign investors, as well as sovereign wealth funds. Most investors assumed the US government would ultimately explicitly guarantee the debt. In May of 2008 Fannie and Freddie issued preferred stock at $25/per share to investors to shore up their balance sheets. Unfortunately these two institutions were so big that the billions raised in this offering quickly evaporated. Within four months the preferred stock was trading at under $2 per share. This calamity forced investors to flee risk at any and all costs. We know the result. Lehman Brothers failed, AIG was taken over by the government, and every asset class save Treasuries got pummeled.
Cumberland’s clients were fortunate. We did not buy any of the preferreds. Our instinct was that the housing/mortgage market was much worse than people thought and there was no guarantee by the government on equity. We had very little invested in the senior debt of these companies. Where we had some exposure was in the mortgage-backed bonds of these companies that held the underlying mortgages as collateral. Our strategy was to buy seasoned mortgage-backed securities and CMOs (collateralized mortgage obligations) created before the housing boom really took off in the last few years. The rationale was that the older mortgages were written when housing prices hadn’t become overvalued and lending standards were more conservative. Those bonds have performed well in our portfolios, generating steady income with little price volatility.
We recently sold all of our positions in the senior debt of these GSEs. There are too many uncertainties and negatives regarding the future of the GSEs. The US Treasury publishes statistics on investment flows into this country from foreign investors (governmental and private sources) on a monthly basis. The most recent statistics, through October 2009, show foreign investors were sellers of over $81 billion in agency debt over the prior twelve months. If the Federal Reserve had not instituted a program to purchase agency debt, yields would have been much higher on their bonds, for lack of buyers. It also would have had the effect of raising rates on mortgages and derailing any recovery at all in the housing sector.
Delinquencies and defaults on mortgages have risen dramatically during this economic downturn. Reserves for such losses are virtually nil on the balance sheets of Fannie and Freddie. The GSEs, with the complicity of Treasury, have not realized these losses and continue to pay investors principal and interest. If they had realized those losses, they would need to go to Congress and request additional funding. This explains why Treasury decided under the cloak of midnight to relax the unwinding and shrinking of these two institutions, and did it before Congress got involved. Congress does not appear to be as acquiescent and accepting as the current administration. Our view is this merely prolongs the inevitable and unpleasant decisions that need to be made regarding these two institutions.
Our view is that the day of reckoning is near on the GSEs. Ultimately the federal government will be forced to explicitly guarantee these behemoths. That result would not necessarily be welcome. Putting Fannie and Freddie on the government’s books will blow a hole through the budget and further strain the government’s resources. It would also cause rating agencies to review and reconsider the United States’ triple-A credit rating. For these reasons Cumberland has purposefully avoided agency and Treasury debt. Happy New Year!
My colleague, David Kotok, is scheduled to appear on CNBC tomorrow (Monday) at 10:30 AM in a panel with Vince Farrell and Michael Farr. GSE and sovereign debt issues for 2010 may be part of the discussion.
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