Are Fannie And Freddie Bonds Too Expensive?

Is Fannie (FNM) and Freddie (FRE) Debt too expensive ?

In other words, is an investor fairly compensated by taking risk and investing in government agency securities? Agency debt is not explicitly guaranteed, but there is an implied guaranty which is not really a guaranty. I have to admit that I’ve sort of lost track of all the government programs. As an investor, it needs to be made more clear.

After researching the Agency Debt, I determined that I didn’t feel as though I was being fairly compensated for the level of additional risk that I would be taking with an investment in Agency Debt versus an investment in US Treasury Debt. I concluded that I also felt less confident about US Government Debt as well.

With regard to FNMA, I feel that the government is still using the implied guarantee to lower the cost of financing for FNMA and FRE, and ultimately the US Government at the expense of the investor.

Here’s some of what I found:

On the treasury website:

• There is an executive order which details preference on payment for holders of FNMA preferreds. FNMA Executive Order - per US Treasury Website. The government by virtue of this document moves their investments in FNMA in front of the common and preferred holders that had invested prior to the governments’ investment.

On the Wikipedia Website :

• The government officials also stated that the government had also considered calling for explicit government guarantee through legislation of $5 trillion on debt owned or guaranteed by the two companies.

• Fannie Mae and smaller Freddie Mac own or guarantee almost half of all home loans in the United States. They face billions of dollars in potential losses, and may need to raise additional, potentially substantial, amounts of new capital as the current downturn in the U.S. housing market continues.

• Markets assume that the taxpayer will if necessary take on the burden of all their mortgages because they underpin the whole U.S. mortgage market. If they were to collapse, mortgages would be harder to obtain and much more expensive. U.S. Treasury Secretary Henry Paulson has said the government’s primary focus is in supporting Fannie Mae and Freddie Mac in their current form.

Did you know that FNMA has the right to defer interest payment on their debt for up to five years if their minimum capital levels fall below thresholds? Read this:

Fannie Mae Subordinated Notes - per FNMA Website :

In order for Fannie Mae subordinated debt to “qualify” for the above-referenced capital calculations, it must require the deferral of interest payments for up to 5 years if (1) Fannie Mae’s core capital falls below minimum capital AND, pursuant to Fannie Mae’s request, the Secretary of the Treasury exercises discretionary authority to purchase the company’s obligations under Section 304(c) of the Fannie Mae Charter Act, or (2) Fannie Mae’s core capital falls below 125% of critical capital. Fannie Mae will take reasonable steps to maintain outstanding subordinated debt issued under the program of sufficient size to promote liquidity and reliable market quotes on market values, and Fannie Mae will undertake to have the subordinated debt rated by at least two nationally recognized statistical rating organizations.

If Fannie needs additional capital, then the government increases the debt ceilings for the Federal Government (as they’ve already done) :

The authority of the U.S. Treasury to advance funds for the purpose of stabilizing Fannie Mae, or Freddie Mac is limited only by the amount of debt that the entire federal government is permitted by law to commit to. The July 30, 2008 law enabling expanded regulatory authority over Fannie Mae and Freddie Mac increased the national debt ceiling US$ 800 billion, to a total of US$ 10.7 Trillion in anticipation of the potential need for the Treasury to have the flexibility to support the federal home loan banks. (Source: Wikipedia)

The Federal Government Balance Sheet is the last resort in financing the agency securities and US Treasury securities. The credit quality of the Federal Government Debt will be the ultimate determinant of whether or not investors into FNMA or FRE or Agency debt will ever see their investments returned to them.

The trend, lately, in the quality of the US Government Balance Sheet has not been one that investors would like to see. The Federal Reserve and the Treasury have decided to purchase “toxic” worthless securities to help free up capital markets. and hopefully avoid a recession. This has had the effect of downgrading the asset quality of the US Government Debt.

This has increased the likelihood of default for holders of Treasury and Agency Debt.; however, I think that it would be unlikely that the US Government would actually default on their debts. They would most likely make all payments of principal and interest when due by printing additional worthless US Dollars.

The negative implications of destroying the credit quality of the US Governments’ balance sheet will be further erosion in the value of the US dollar. As the US dollar erodes, foreign governments will be less likely or willing to purchase our new offerings of Government Debt. The effect will be the same. A further tightening of credit conditions. Less ability to finance. At some point foreign governments, mainly China and Japan will no longer want to hold our US Government Bonds.

The resulting effect will be a major spike in interest rates and a potential collapse of our financial system as we have known it. I think an investor in agency debt needs to consider all of these factors when considering investing in Agency or Treasury debt today. It’s not the same as it was last week.

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