Still bleeding

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Aug 20th 2008 | NEW YORK
From The Economist print edition

Fannie, Freddie and Lehman ensure August is anything but quiet

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WITH blood stocks in New York perilously low, health officials in the city this month issued an emergency appeal for donations. The lifeblood of financial institutions—confidence—is in equally short supply. Five months after the Bear Stearns debacle, and a month after America’s Treasury unveiled unprecedented measures to support the mortgage market, some whose share prices had hinted at recuperation only a couple of weeks ago are once again looking dangerously anaemic.

At the top of the critical list are Fannie Mae and Freddie Mac. The quasi-private mortgage agencies are in danger of being overwhelmed by losses on their holdings of mortgages and mortgage-backed securities (MBS). Ajay Rajadhyaksha of Barclays Capital estimates that Freddie’s balance-sheet has a negative value of at least $20 billion when marked at market prices; Fannie is $3 billion in the red. Both saw their share prices fall by more than 20% on Monday August 18th as the odds of government intervention that wiped out existing shareholders shortened.

Loss of faith in the firms’ equity is one thing, ebbing confidence in their vast pile of debt altogether scarier. Spreads on the $1.5 trillion of paper issued on their own behalf have widened significantly. A five-year issue by Freddie on Tuesday sold for 1.13 percentage points over treasury bonds, the highest spread for at least a decade. As recently as May, Freddie had found takers at 0.69 points over treasuries.

A sudden pullback by overseas investors is largely to blame. Foreigners, mostly Asian central banks and funds, hold 35-40% of the mortgage agencies’ total debt. They continued to be avid buyers this year, but their appetite waned dramatically in the first half of August. American money managers have taken up the slack, but they too are becoming twitchy, according to a market participant.

The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks. The spread on the securities has risen to around 2.2 percentage points over government bonds, even wider than it was during March’s turmoil (after adjusting for today’s lower volatility). This has helped to push up interest rates on the “conforming” mortgages that Fannie and Freddie buy or guarantee, at a time when private finance has slowed to a trickle.

The banks that manage the agencies’ debt issues are pulling out all the stops to ensure their success—even to the point of artificially boosting demand through deals known as “switches”. In such an arrangement, an investor agrees to buy into a new issue in return for being able to sell back to the banks an equal amount of an old one, thus ensuring its net exposure does not rise. If enough of these deals are struck, large amounts of debt can be shifted even when demand is thin. A recent $3.5 billion issue by Fannie was helped along by “very significant” amounts of switching, says one banker involved in it. With a quarter of the agencies’ debt due to mature in less than a year, those charged with peddling it will have their work cut out—especially if the Asian investors continue to be put off by unkind headlines.

This is not what Hank Paulson, America’s treasury secretary, envisaged last month when he announced an emergency plan to rescue the twins. By pledging to invest in them if needed, he had hoped to calm markets and thus reduce the likelihood of a bail-out. That gamble looks ever less likely to pay off, however.

If a government recapitalisation does prove necessary, the treasury is likely to take one of two routes: a preferred-stock investment that allows the agencies to raise more capital of their own, or nationalisation through a common-equity injection that leaves current owners with nothing, and thus offers the taxpayer a better deal. Jeffrey Lacker, head of the Richmond Federal Reserve, this week threw his weight behind the second option.

This comes against an increasingly bleak backdrop. Lehman Brothers, the smallest of the four remaining full-service investment banks, is still struggling to persuade the stockmarket, and its clients, that it has a future on its own. Faced with another hefty quarterly loss, it is shopping both its worst assets (a toxic commercial-mortgage portfolio) and its best (Neuberger Berman, a fund manager). Selling a chunk of Neuberger would raise much-needed funds, but it would also leave Lehman looking far less diversified and less stable than it would like.

This week Goldman Sachs, the only investment bank still in decent shape, cut profit forecasts for all of its main capital-market rivals, including Lehman, citing the need for further write-downs and a drought in key business lines. (Some analysts had cut their Goldman forecasts the week before.) It also released a scathing report on American International Group, putting its losses from mortgage-related swaps at up to $20 billion, and even suggesting the giant insurer could suffer an “impairment of counterparty confidence”. The rate at which big banks lend to each other, meanwhile, hit a two-month high. One of them may go bust in coming months, mused Kenneth Rogoff, the IMF’s former chief economist, adding his name to the lengthening list of those who think the worst is yet to come. Given what has already been endured, that is a blood-curdling thought.