Subscribe to this blog's feed(links from Calculated Risk...) The GSEs are technically insolvent, Bloomberg says. Are they going to fail? No, Fortune says - they've got implicit guarantees.
In that case, why doesn't the market believe them? GSE CDS are trading at levels more suited to A2-rated companies than the AAA ratings that both still have.
Ed Kim reasons that therefore
either the market doesn't expect the guarantee to be upheld, which implies shocking things for the housing market (as the Fortune article points out);
or the market expects the guarantee to be upheld, but the US government has such a huge deficit that it won't be able to bail them out - effectively, that the US government itself should also be downgraded to A2, which implies shocking things for, well, everybody.
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...
Given this analysis - which seems to be both accurate and (no insult intended) pretty obvious - it's likely that the financial side of the US government is, as an American would say, punting this issue; hoping that default rates won't rise sufficiently to force the moment of truth. I think this is unlikely to succeed.
