Between the Lines: The $45 trillion gamble of Fannie and Freddie bailout

Published on Tuesday 9 September 2008 21:13

WELCOME to Fannie Mae's and Freddie Mac's party: the morning after the night before. The decision by the Bush administration, in its dying days, to nationalise the two ailing mortgage financiers has certainly raised the animal spirits of the world's equity markets. But the cheering could be short lived. The real question is: which dominoes will fall next?

The instant answer appears to be the medium-sized and regional banks in the US, which were heavy investors in the preferred stock of Fannie Mae and Freddie Mac. While the two mortgage financiers relied on bond sales for liquid funds (before that source dried up), they issued preferred stock to cover their reserve capital requirements. Heavy investors in this stock include Gateway Financial, Sovereign Bancorp, Wells Fargo and Midwest Banc. Unfortunately, this preferred stock is virtually worthless after the US Treasury cancelled all dividend payments.

Sovereign Bancorp, based in a Philadelphia, is one of the biggest losers. It was holding more than $600 million of Fannie and Freddie preferred securities at the end of the second quarter. That represented between 13 and 14 per cent of its capital, which will have to be refinanced. Wells Fargo admitted on Monday that it owned nearly $500m worth of Fannie and Freddie preferred shares.

I don't want to exaggerate the extent of the fallout for these bodies – we will know for sure on 30 September, when US banks must post the assets on their balance sheets at fair market value. But I do want to underline the fact that the takeover of Fannie and Freddie will have unintended consequences. The current crisis represents not just the bursting of a credit bubble, after which everything returns to normal. We are dealing here with a systemic failure of the financial system that won't be resolved by emergency nationalisations.

If we are lucky, the rescue of Fannie and Freddie may end the chain- reaction of credit defaults and give us time to redesign the architecture of international banking. More likely, we will have to endure further pain. The ultimate problem with the system – the ticking bomb, if you like – is that the consequences of risk-taking have been so divorced from the initial risk-taker, that no-one knows where the buck stops. Every time we think we have plugged one leak in the system, the pressure blows another hole.

Let me give you an example: credit default swaps (CDS). A crisis in the CDS market could be another unintended consequence of the nationalisation of Fannie Mae and Freddie Mac – only this time it gets really serious.

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities – a bond issue, say – in the event of a default. The buyer of the credit default insurance pays premiums over a period, in return for peace of mind, knowing that losses will be covered if a default happens. It's equivalent (in theory) to taking out home insurance.

However, in the hothouse atmosphere of the past decade, CDSs were transformed from a legitimate insurance practice into a casino game. Because a CDS has a stream of income (the premiums) it is a valuable asset that can be traded. And during the boom, the idea that anyone would actually have to pay out because of a default seemed ludicrously improbable.

Banks and hedge funds were soon trading in CDSs – but without any official regulation to ensure that buyers had the resources to cover any losses, if the covered security defaulted. An original CDS can go through 15 or 20 trades, so if a default occurs, the so-called insured party doesn't know if the end player has the resources to cover the default.

All this sounds obscure and "techie" until you grasp the astonishing scale of the CDS market – and hence the liabilities at stake. One authoritative estimate puts their combined value at $45 trillion in mid-2007. That far exceeds the $7 trillion US mortgage market, whose imminent failure prompted the nationalisation of Fannie and Freddie.

Here is the problem: CDS contracts specify that the payouts are initiated automatically as a result of government intervention such as the Fannie Mae and Freddie Mac takeover. That means whoever was left holding the CDS parcel must pay up if required to do so by the premium payer. And they could be anybody, not just an institution that holds Fannie or Freddie securities. Analysts are predicting that the Fannie and Freddie takeover could trigger the largest credit default swap payments ever. Suddenly those multiple billions of dollars of CDS assets could be threatened.

Fortunately, since the credit crunch began last year, institutions have been busily writing-down the value of the CDS portfolios. For instance, American International Group, the world's largest insurer, wrote down $11 billion on its CDS holdings, thereby incurring the biggest loss in the company's history.

However, the lurking danger with CDS instruments lies with the hedge funds, which have so far escaped the worst of the credit crunch. Hedge funds now dominate the CDS market. Often they bought credit insurance hoping other companies or securities would go bust and they could claim the payout. But it looks less and less likely that the insurers – the folk who ended up with CDS instrument after all those trades – will have the cash to meet their obligations, which means the hedge funds could be sitting on assets that are worthless.

It could be that the hedge funds have been too clever for their own good: as fears of a global recession have increased, hedge funds have been marking up the value of their assets, while rubbing their hands at the thought of all those lovely insurance payouts. But the insurers most probably don't actually have the cash to pay out.

This is one reason why the New York State insurance superintendent, Eric Dinallo, forced Merrill Lynch to unwind $3.7bn of CDS insurance it had bought on mortgage obligations. Merrill agreed to take only $500m from XL Capital to terminate the CDS contract – that's 13 cents in the dollar, but better than nothing.

Dinallo thinks that the valuations of CDS contracts remain "absurdly optimistic" on both the books of the insurers that wrote them and the companies that bought them.

The US Treasury had no alternative to nationalising Fannie and Freddie. Now wait for the hangover.