Fannie Mae and Freddie Mac have had a few good trading days this week, but they’re still ripe for a near-term Treasury bailout if capital problems persist. As NY Times writer Gretchen Morgenson pointed out Sunday, this bailout is complicated by credit default insurance (or swaps). She’s covered this otherwise under-reported area of the credit crunch well this year starting with this credit default insurance primer (also this summarizes swaps well).
Most people following along know that if Treasury took over Fannie/Freddie, holders of common stock lose as common shares get diluted by Treasury preferred holdings. But Morgenson, using a UBS research report, pointed out a bigger problem: If Fannie/Freddie are under capitalized to the point of Treasury stepping in, they can stop making payments for five years on their $19 billion in subordinated debt (one of the many tiers in their capital structure). This is technically a default, and there is a ton of credit insurance that’s been purchased to protect against defaults.
Nobody knows how much but the market is huge: about $62 trillion of credit default insurance was written through late-2007—this is about four times larger than the U.S. stock market. A lot of people would want to get paid a lot of money if Fannie/Freddie defaulted on their subordinated debt in a bailout. Other recent bailouts provide signals of who would get paid.
When Countrywide and Bear Stearns were bailed out by Bank of America and JP Morgan Chase respectively, three things happened:
(1) Investors who owned CWC or Bear bonds, and bought insurance to protect themselves against defaults, lost premiums they paid for the insurance because the bailout meant there was no default—but they could work out deals to have their CWC/Bear bonds replaced by stronger bonds of acquiring companies.
(2) Speculators who didn’t own CWC or Bear bonds, but bought credit default insurance as a bet these firms would fail, lost big—they lost premiums they paid for insurance AND their insurance value got wiped out when the value of the CWC and Bear bonds (they didn’t actually own) increased because of the takeover.
(3) Issuers of credit insurance made out because they kept the money they made on premiums from investors and speculators.
As Morgenson said earlier this year, this could be a template for a Fannie/Freddie bailout structure. They’d do everything they can to honor obligations of actual subordinated debt holders with credit insurance, and let the speculators who hold insurance on subordinated debt (but don’t actually hold the debt they’re insured for) sink. Seems logical that a speculator using credit insurance to bet against a company without actually holding that company’s debt should suffer.
Don’t worry if you don’t see logic and are just confused by all of this … Everyone is because, since credit insurance is unregulated, nobody knows how much credit insurance speculators or investors hold.
Treasury Secretary Henry Paulson is one of the few who could actually sort this out over time. Many think Paulson’s the best person to run a government-controlled Fannie/Freddie entity and restructure them appropriately for the ultimate goal of privatization.
But it’s possible he doesn’t want the job. If market events don’t force Treasury to bail out Fannie/Freddie before the election, everyone should hope for the sake of U.S. economic survival that our new Treasury secretary is a proven finance leader like Paulson and not a financial lobbyist lapdog like McCain’s short-list choice for Treasury Phil Gramm.
Gramm was a key architect of the credit crisis, first leading the repeal of Glass Stegall which allowed consumer/commercial banks to merge with investment banks. Then slipping 262 page “CFTC modernization” provision into a December 2000 spending bill that exempted energy trading from regulation (leading to the Enron debacle) and also exempted credit default swaps from regulation (leading us to the topic at hand).
We’re hoping Paulson steps in now. But he’s also got a passion for the environment, so perhaps he’s just stalling until the election passes and he can focus that.