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Wednesday, August 20, 2008

Testing Paulson's Resolve?

By Claus Vistesen Copenhagen

It never rains, but it pours; so goes an old adage and while the US authorities are still scrambling to figure out just what to do in the context of the erstwhile jewels, but now broken, mortgage giants Fannie and Freddie Mae foreign investors are beginning to vote, as it were, with their feet. As such, the big news so far this week must certainly be the extent to which portfolio managers at foreign central banks held suspiciously back in their hunger for Freddie Mac's three year note auction. Reuters and the IHT provide the details.
On Tuesday, Freddie Mac had to pay a steep premium on a $3 billion issuance of five-year debt. The company will pay an interest rate of 1.13 percentage points higher than the rate the U.S. government pays for comparable borrowing. Earlier this year, the premium was as low as 0.6 points, according to Bloomberg.

Even with Freddie Mac's debt promising investors a rich return, overseas demand for the issuance was weaker than in the past. Asian investors bought about 30 percent of the debt, while Europeans took 10 percent, according to a person familiar with the offering. By comparison, for the 12 months leading up to July, Asian investors accounted for 36 percent of the company's debt and Europeans held 15 percent, according to data released by Freddie Mac.

Apparently, the notion of a risk free rate and by derivative security is a rather fickle concept not least in this context where hitherto government grade paper now has to pay a premium 30 bp above the one levied just a few months ago. As always however, there is a silver lining. In this case, it would go something along the lines of how especially foreign institutional investors are cashing in on the call option which was explicitly handed to them as congress approved secretary Paulson to do "whatever it takes" to ensure that the agencies did not run into a default. Moreover, the script for this play was typed already in the immediate aftermath of the Fannie/Freddie bust, as institutional portfolio managers from Asia in particular were quick to denounce the increased risk on their holdings. The main emphasis was consequently that our good foreign fund managers were not holding equity from Fannie and Freddie Mae (which was visibly getting flogged), but rather their debt; and that, naturally, was all but secured by the government.

As such, and perhaps as a sign of good faith Freddie Mac's offering on the 18th of July was munched with great appetite as 61% of the auction was taken by foreign investors (of which 34% going to Asia); a number which was actually up from the previous 55% at the May meeting. Good sentiment abound treasurer at Freddie Mac
Timothy Bitsberger simply noted;

While some investors may have lost confidence in the companies, all I know is that we've been able to sell paper this week.

Well, that was then and this is now and in light of this week's meager demand, and subsequent increase in yield, Paulson is getting closer to the point where he has to pay for the option issued to the holders of agency debt. Brad Setser who also devotes a piece [1] to this topic seems to be getting to the center of things when he says:

(...) it certainly seems like the GSE’s creditors aren’t in the mood to extend credit just on the expectation that the GSE’s will be backed by the government if there is a need. The world’s central banks want to the Treasury to show them some money. That means changing the GSE’s current structure.

That sounds about right to me and yesterday's price action tells us as much. Brad also makes the succinct point that whatever yield the GSEs (government sponsored entities) would be able to pay above the benchmark treasury, it would certainly not be enough to compensate reserve managers from a potential default. This is to say that as long as the debt remained in some kind of quasi government backed limbo, the potential yield offered over treasuries would not suffice [2]. Of course, this is almost an argument non-sequitur because there is also a simple limit to the premium Fannie and Freddie could afford to pay on the outstanding debt without having to tap federal resources on the back of the interest expenses alone. I mean, either you mark to market, junk bond style, or you tie up the government guarantee in a formal arrangement. Remember too that the more Fannie and Freddie have to pay to finance their going concerns, the more expensive it becomes for holders of mortgages to finance and re-finance.

Add to this the small detail of the incoming debt roll-over just shy of a quarter of a trillion and I think the future of the GSEs is pretty much bent in neon. Paulson et al. will have to knit together a working solution which involves federal funds. It aint going to be pretty and the rascal in me (and others) would have no trouble seeing foreign reserve managers suffering from the party hangover they themselves contributed to. But at this point it seems, there really does not seem to be any alternative.

Cat and Mouse, but who is who?

In a more general light this is obviously a cat and mouse game, and one particular game where the roles are not ex ante assigned. In this way, one could ask with reasonable legitimacy whether in fact the small but significant demonstration this week constitutes a credible threat?

At a first glance it sure does look like the Petroexporters, Asia et al. are holding all the aces. The US does not only need to do something about the GSEs in order to shore up what must clearly be coined a dubious arrangement; there is also the small detail of the external deficit and what would happen if foreign investors decided to shun agencies. Obviously, if they decided to park their funds in treasuries in stead it would actually help the US economy as it would make it de-facto cheaper to finance the inflows needed to cover the external balance. Paulson is not likely to be that lucky however which suggets, more than anything, that some variant of a bail out is coming. Otherwise, the ensuing panic would be immense.

However, there is a different way to interpret this tune. As such and while the US definitely needs to make domestic debt attractive to foreign investors in order to attract inflows [3] so do foreign holders of agency debt need to protect their investments and USD denominated assets. This goes back to my argument of a potential point of no-return that basically suggests how major foreign agency holders, at this point in time, cannot afford a default or crash anymore than the US economy can. In a wider context it also cuts laterally through the discussion on global imbalances and where funds should flow. Sure, the USD and its associated debt looks rather rubbish at the moment but if you are unwilling, or more importantly unable, to muster the subsequent boomerang effect from a tanking USD then it suddenly becomes a little bit more complicated. Add to this that a candidate towards which the SWFs, reserve managers and other savers of the world could plausibly put their money does not seem to be on the table at the present time. At least, there is no single candidate which incidentally also makes a new variant of a Plaza agreement rather difficult to knit together. This would then exemplify the global game of old maid in which everybody can the see the impetus for the US economy and her currency to correct, but also where the process is gridlocked by the fact that the role of global capacity absorber/consumer of last resort remains equivalent to holding the old maid.

[1] Not only Brad Setser massages this topic. I would highlight Yves Smith and her commentary section in particular; Setser's comments section is good too by the way.
[2] Or this, as it were, is how I understand it.
[3] On a longer term, portfolio inflows pertaining to equity are sure to favor the US too.