Sunday, September 7, 2008

Overseas Markets Rejoice in US Government Bailout of GSEs

Hank Paulson's plan to seize Fannie and Freddie is being greeted by cheers from overseas markets, with stocks soaring and financials performing particularly well.  It is no surprise that overseas markets like this plan.  For one thing, central bankers around the world are breathing a big sigh of relief.  After all, foreign central banks were big buyers of agency debt and were probably sweating bullets at the recent significant widening of spreads on agency debt on the panic over Fannie and Freddie's solvency.  Now that Mr. Paulson has laid out his plan which protects holders of Fannie and Freddie's debt by injecting capital if and when equity ever turns negative, central bankers don't have to worry about any embarrassing phone conversations with bosses where they have to explain how they lost the country's reserves on "speculative" investing.
Meanwhile, futures on the Dow and S&P are pointing to a sharply higher open in the US as well.  Treasuries are selling off as the "flight to quality" trade is no longer as compelling.  Given that the government will now be buying MBS outright in the market as part of Mr. Paulson's plan, it is logical that MBS spreads should narrow significantly in anticipation of the government's purchases.  However, this is one part of the plan that was somewhat ambiguous.  The plan did not specify how much MBS the government planned to buy, only that it wanted to lower mortgage rates for borrowers seeking new mortgages.  If the government is serious about affecting the spread then it will more than likely need to buy large quantities of mortgages.  A few weeks ago, I jokingly suggested that the Fed should buy agency debt to take advantage of the juicy spread between agency debt and where the Treasury borrows money.  The Treasury will basically be doing this when it begins buying MBS, holding the securities to maturity and managing the portfolio.  Part three of Mr. Paulson's plan is to turn the US government's balance sheet into an MBS hedge fund.  But I have to admit, if I could borrow unlimited amounts of money at 3.80% for ten years, I'd be looking for all sorts of high yielding assets to purchase and "hold-to-maturity."
In any event, it looks like the market will rally, at least in the short term.  This will be the big capitulation event that everyone was looking for.  No matter that Bear Stearns was the "big capitulation" event a mere six months ago and a huge failure of that magnitude was sure to mark the end of the credit crisis.  Here we sit now with two much larger failures (and several smaller ones in between), involving government guarantees yet again.  This bailout doesn't really change the deteriorating fundamentals of the housing market, it merely helps restore a modicum of liquidity to the mortgage finance market.  Yet another emergency plan was cobbled together in a rush to avoid a market meltdown, along with the Bear bailout, and all of the Fed's fancy new liquidity facilities for Wall Street banks.  We'll see how long the euphoria lasts this time.    


Anonymous said...

Spot on analysis. For a moment I just wish Hank and Ben had bought the GSE paper for the past 3 weeks and sold notes to take advantage of the arb. so the taxpayer could profit (or at least reduce losses) from some insider trading.

K10 said...

It is too bad that Hank and Ben didn't do. But the conspiracy theorist in me wonders if Morgan Stanley did. The potential conflicts of interest arising from hiring Morgan Stanley to craft the Treasury bailout of FNM and FRE are so huge that I'd want someone from the SEC sitting on their trading desks making sure they didn't profit from this.