Wednesday, July 9, 2008

Downgrade U.S. Government’s Credit Rating To "A2"?

With the news out that derivatives traders are treating Fannie Mae (Fannie) and Freddie Mac (Freddie) as if they should be rated “A2”, five levels lower than the implied government backed rating of Aaa. According to Bloomberg, “Credit-default swaps tied to $1.45 trillion of debt sold by the two biggest U.S. mortgage-finance companies are trading at levels that imply the bonds should be rated A2 by Moody's Investors Service,”

What the derivative market is saying, in essence, is that the likelihood of Fannie and Freddie being able to repay their obligations in full is in doubt. Taking this logic couple of steps further, since Fannie and Freddie have implicit backing of the U.S. Government, this implies that either (1) the implicit guaranty means nothing to the derivative market, and therefore they do not expect the government to bail out Fannie and Freddie; or (2) even with the implicit guaranty of the U.S. Government, the likelihood of being made whole is in doubt since the Government is already operating in a deep deficit.

Both scenarios bode very badly for the U.S. economy. I have stated this sort of problem in my March 19th article:

“Should losses in the 4% to 5% range occur, Fannie and Freddie will require immediate capital injection. Moreover, this would cause substantial losses in the market. After all, if Fannie and Freddie, the two truly “can’t fail” companies begin teetering, then the entire market will begin free falling.

The probability of this risk event unfolding is high given the continuing deterioration in the real estate market and with nearly $700 billion in ARM mortgage interest rate resets to occur in 2008. If the projected defaults increase substantially over the historic average, then the Federal Government will be forced to step in with tens of billions dollars in capitalization. And guess where that money is coming from.”

Let’s take some hypothetical looks at how this scenario might play itself out:

(1) Fannie and Freddie obtain capital injections from SWFs or private funds. The market will see the capital raise, as a red flag and drive the credit default spread even higher, a scenario that I think will definitely happen.

Since the cost of capital has increased substantially, the cost of the capital raise, in the capital market, will negatively affect Fannie and Freddie’s net income for years to come, if they can even obtain the capital. This too will have a long-term negative affect as more income is diverted to servicing the cost of capital. Again, the credit default spread will go even higher. This is another likely scenario, in my view. The stock prices of these two may see a little bounce; dead cat version, in my view.

(2) Fannie and Freddie fail to obtain capital injection or the funds raised are deemed to be inadequate. The market will see this as a very bad sign – double red flags – and begin abandoning their positions in Freddie and Fannie, and causing a substantial dislocation in the global market; a scenario that I hope does not happen but has an outside chance of occurring.

(3) The Federal Reserve, at the urging of the U.S. Government, steps in and provides the same short-term liquidity injection that Wall Street received (Term Securities Lending Facility). The Fed will take Fannie and Freddie’s junky bonds in exchange for UST (U.S. Treasuries), at very favorable terms. This, too, is a likely scenario, in my view.

This will increase the risks I have outlined in my March 11th article: (a) increasing the credit malaise, (b) driving away foreign investors in UST and causing the rates to rise, (c) lowering the value of the U.S. dollar, (d) driving the U.S. economy further into hyperinflation. While this move will lower the credit default swap spread, it will cause more upheaval in the bond market and drive the stocks of these two down substantially.

None of the three above scenarios are pretty. It is basically choosing the lesser of the evils at this point. It is clear at this point that the market does not believe the U.S. government’s desire to step into save Freddie and Fannie and any move by them to raise capital will trigger further widening of the default swap rate.

With the potential for housing prices to decline 10% to 20% further, the mortgages on Fannie and Freddie’s books are looking very suspect. A typical loss (haircut) given on the balance of a mortgage is 10%. Based on the $1.4 trillion in debt outstanding, a haircut of 10% results in a potential loss of $112 billion.

$1.4 trillion x 10% mortgage write-off x 80 cent loss per $1 = $112 billion in potential losses, nearly 146% of the estimated 76.8 billion in reserve capital, estimated as of December 2007.

Fannie and Freddie may not survive in their current form, after all the losses have been tallied. Batten down the hatches because here comes the other side of the hurricane!

Ed Kim
Practical Risk Manager

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