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Long-simmering concerns about management and regulation of U.S. housing agencies Freddie Mac and Fannie Mae came to head on June 9, with news of a clean sweep of Freddie's management. The agency's president was fired for allegedly failing to cooperate in a probe of Freddie Mac's derivatives accounting, and its CEO and CFO were each forced to resign (see BW Online, 6/13/03, "Why Freddie's Mess Matters").
The credit markets sat up and took notice: Interest rate spreads between Fannie's (FNM
) and Freddie's (FRE
) debt and U.S. Treasury debt widened considerably, indicating that investors saw them as suddenly carrying a greater degree of risk -- and sparking flight-to-safety buying of Treasuries.
And yet many pundits have expressed optimism that Freddie's woes are an issue of management style over portfolio substance. Let's hope so. Any signs of coverup, irregularities, or fraud
could prove damaging to the anemic U.S. economic recovery and certainly will command the full attention of the Federal Reserve.
STRONG SUPPORT. Indeed, while we at MMS International expect the Federal Open Market Committee to cut the Fed funds rate by 25 basis points at the June 25 policy meeting, a run on agency debt could boost the likelihood of a 50-basis-point cut -- in addition to spurring Alan Greenspan & Co. to adopt more unorthodox policy measures, such as bond purchases.
Strength in the housing sector has been a key pillar of the U.S. economy, supported by record low mortgage rates and successive waves of refinancing activity. These have beefed up Americans' home equity -- and vastly improved household balance sheets. The housing agencies have played an integral and implicit role in supporting the economy, greasing the wheels by securitizing over 40% of the $2 trillion of mortgage debt taken down in recent years.
Critics argue that as government sponsored enterprises (GSEs), Freddie and Fannie unfairly leverage their relatively small government credit lines to borrow on near risk-free terms, though implied government backing is minimal. This allegedly allows them to dictate terms to the market and stifle competition, actions beyond their original public charter.
HEALTHY FINANCES. To some extent, the agencies may be victims of their own success, with their impressive size and market dominance justifying tighter scrutiny and higher standards of disclosure. The drastic action by the Freddie Mac board, sacking its own management, shows some grit. Moreover, its financial restatements are actually expected to "materially increase" its earnings and capital surplus for the past three years. Yet, this is expected to come at the expense of greater earnings volatility -- and potentially lower earnings per share (EPS) -- in future periods.
Technically, Freddie appears to be on solid ground, and Standard & Poor's Ratings Group has affirmed its debt ratings, though its credibility has been dented considerably and the stock price hammered. (Freddie shares have fallen some 22% since the news of the management shakeup broke.)
Even its beleaguered regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), says concerns remain about Freddie's "management, practices and controls," though its "asset quality and capital positions remain strong."
FOREIGN HOLDINGS. The issue even extends beyond U.S. borders, given the popularity of agency debt with overseas investors. Seeking to retain trade competitiveness, Japan and China have amassed huge dollar reserves in the process of aiming to forestall appreciation of their currencies. This has helped slow broader dollar depreciation and contributed to record low interest rates.
Fed custody data revealed a $933 billion surge in foreign central bank holdings of U.S. government and agency debt, with about 40% of that recycled into agency debt the past few quarters. Any flight out of these holdings could sharply drive down the dollar, push up market yields, and test the government's commitment to backing agency debt.
Fed Governor Susan Schmidt Bies recently weighed in on l'affaire Freddie, saying somewhat wistfully that she saw "no short-term impact from the Freddie Mac turmoil on the economy" and that the "housing market is still very strong."
PREVENTION PAYS. With the Fed still saddled with "a sluggish economy" and grappling with deflation risks, stability in the housing sector will be a top priority, Bies said. She also confirmed that, while the central bank had no direct regulatory authority over the agencies, it was actively conferring with regulators and prosecutors in the case.
Indeed, Fed Chairman Alan Greenspan has been critical of the implied government subsidy of GSEs and wouldn't be pleased if the Fed was left holding the bag in the remote event that one of these institutions collapsed. The course of action is clear for regulators and policymakers alike: To paraphrase the Fed's mantra on deflation, it would be much easier to prevent a Freddie-sparked economic crisis in the first place than pick up the pieces afterwards.
Wallace is a senior market strategist for MMS International
All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure
Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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