Wednesday, August 20, 2008

Rising Cost of Debt Stokes Fears On Freddie's Prospects

(WSJ) Freddie Mac was forced to offer unusually rich terms to investors in a $3 billion auction of its debt, raising anew concerns about the health of the mortgage giant, a vital prop for the U.S. housing market.

Investors increasingly believe the U.S. government will take steps to rescue Freddie Mac and its sibling, Fannie Mae. The Treasury Department recently received authority from Congress to bail out the two companies, although it stopped short of doing so. Both now play a dominant role in financing mortgages. A rise in the companies' borrowing costs could translate into higher mortgage rates for consumers, prolonging the housing slump.

The worries about Fannie and Freddie and the weak U.S. housing market in general contributed to a global stock market selloff that left major indexes down about 2%. In the U.S., the Dow Jones Industrial Average fell for the second day in a row, dropping 130.84 points. Shares of banks and brokers declined, with Lehman Brothers Holdings leading the retreat, falling 13% to $13.07.

Shares of Freddie and Fannie, which were down more than 20% on Monday, fell 5% and 2% on Tuesday, respectively, as investors worried that a government aid plan would wipe out the value of their stock holdings. The decline in the companies' share prices and the high interest rates they have to pay for their bonds could themselves hurt Freddie and Fannie by causing investors to lose confidence.

[Rising Risk Premium]

Last month, Congress granted Treasury the temporary authority to take an equity stake in the firms or loan them an unlimited amount of money. Treasury Secretary Henry Paulson has said the government has no plans to use the authority granted by Congress to shore up Freddie Mac and Fannie Mae. But Mr. Paulson wants a plan ready in case the government has to step in, according to people familiar with the matter. The Treasury Department has been wrestling with how to structure such a rescue, should one become necessary, these people say.

One concern at Treasury is that market conditions can deteriorate quickly, necessitating a fast response. Mr. Paulson was heavily focused on the question during his long return flight home from the Beijing Olympics last week. A key consideration is whether the companies can fund themselves, which Freddie Tuesday demonstrated it was able to do.

The company, however, had to pay hefty interest rates. The five-year notes were priced to yield 4.172%, or 1.13 percentage point above yields on safe Treasury notes, the highest "spread" Freddie has ever paid on such debt.

Underscoring the significance of any government intervention, senior Wall Street executives have suggested to Treasury it might look to historical examples such as the 1984 rescue of Continental Illinois, a Chicago bank whose collapse still represents the biggest-ever bank failure.

Both Treasury and the companies are in somewhat of a bind. The government is reluctant to intervene and had hoped to reassure markets by asking Congress for temporary authority to take an equity stake in the firms or loan them money.

Meanwhile, Freddie's ability to raise capital, and therefore avoid a bailout, is constrained by the uncertainty created by the government's deliberations, according to people familiar with the matter. Investors are unlikely to buy new Freddie shares if they fear the government might mount a rescue that would hurt the value of those shares. Freddie executives are due to meet with Treasury officials Wednesday to discuss the situation and the two sides may explore whether the Treasury could clarify its intentions in a way that would reassure investors.

Mr. Paulson asked for the authority as a means to reassure the markets that the government wouldn't allow the companies to fail. But the companies' share prices have continued to fall as investors fear that the two won't be able to avoid a government bailout. Fannie and Freddie own or guarantee more than $5 trillion of home mortgages or nearly half the total outstanding.

The companies' increasing financing costs tend to push up mortgage rates paid by consumers. Mortgage applications are at their lowest levels since December 2000. For the week of Aug. 8, applications were down about 37% from a year ago, with purchase applications off 32% and refinance applications down 44%, according to the Mortgage Bankers Association.

Series of Options

Two weeks ago, Treasury hired investment banking giant Morgan Stanley to help it "analyze and understand these authorities, should circumstances ever warrant their use." Morgan Stanley bankers are working with Treasury staff to come up with a series of options it could use to shore up Fannie and Freddie depending on various market conditions.

Among the issues being debated is whether to force out management as part of any investment or loan. There is also debate about what to do about the companies in the long term. If Treasury were to take an equity stake at a high price, it would benefit shareholders. Coming in at a low price would essentially wipe out the shareholders, making the government the de facto owner of the firms. It's not clear whether Treasury would treat both companies equally or devise a rescue for one and not the other.

Some market observers say an investment or a loan from the government will perpetuate a model that no longer works. Fannie and Freddie are government-sponsored enterprises -- meaning they were chartered by Congress -- and yet also public companies. "The better step would have been to have legislation that would have permitted them to be taken over immediately," said Peter Wallison, a former Treasury general counsel and critic of the companies.

[Marked Down]

As home prices continue to fall in much of the country, the collateral backing loans guaranteed by Fannie and Freddie is dwindling in value. Zillow.com, a provider of real-estate data, released an estimate Tuesday that 14% of U.S. homeowners -- about one in seven -- owe more in mortgage debt than the current market value of their home.

One option for both companies is to reduce their purchases of home loans and related securities to conserve capital. But that would reduce the flow of money into the market and push interest rates up for consumers, perhaps prolonging and deepening the housing slump.

Still, investors did show up for Freddie's Tuesday auction. Asian investors, traditionally large buyers of agency debt, made up 30% of the demand, while European investors made up 10%. North American investors, including many investment managers, picked up much of the slack; they contributed 59% of the demand. In Freddie's previous note auctions over the past year, total Asian and European investor demand averaged 51%, versus the 40% this week.

'Litmus Test'

Most central banks and foreign investors fully expect the U.S. government to stand behind Fannie and Freddie's debt obligations. But many are already holding significant amounts of the companies' debt and are unwilling to add to their positions at a time of uncertainty.

"The worry is not that they won't get their money back, but that negative headlines will continue and it will be hard for them to explain why they are adding to their positions at this time," says Ajay Rajadhyaksha, head of U.S. fixed-income research at Barclays.

Some analysts think Treasury needs to act faster to put its plan into action by injecting fresh capital into Fannie and Freddie as soon as possible.

Freddie's auction was a "litmus test of support from Asian investors," said Michael Cheah, a bond-fund manager at AIG SunAmerica Asset Management in Jersey City, N.J. "The market dodged the bullet today, but from now on, every...auction is going to be a cliffhanger," he added.

Freddie officials were upbeat about the sale. "We are pleased with how it went down," a spokeswoman said. "It was a large offering, and that it was oversubscribed points to the fact that our liquidity position and access to the world's capital markets remains very strong."

She noted that spreads on the debt of many other financial companies have been widening in recent weeks, and that August is typically a slow month for the markets in Asia.

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