Credit insurance obligations cloud bailout of Freddie, Fannie


What Will Mac 'n' Mae Cost You and Me?

By Gretchen Morgenson
The New York Times
Sunday, August 24, 2008

The inevitability of a taxpayer-funded bailout of Freddie Mac and Fannie Mae, the hobbled mortgage behemoths, shook investors last week, and shares in both companies plummeted on fears that existing stockholders would be wiped out.

These government-sponsored entities guarantee or hold $5.2 trillion in mortgages and have been hammered by defaults across the nation. Fannie Mae's shares closed on Friday at $5, down from almost $70 a year ago. Freddie Mac fell to $2.61, which is down from about $65. Their heavily leveraged balance sheets magnify even a small rise in delinquencies.

There is no certainty about what form a Mac 'n' Mae rescue would take. Naturally, this is giving investors the jitters. Up and down Fannie's and Freddie's capital structure, debt and equity holders want to know how a bailout would affect them.

It is widely assumed that debt issued by Fannie and Freddie will be backed by the taxpayers. Call it "too big to fail times two."

But in our highly interconnected financial world, where one company's ills have the potential to infect many others, no bailout exists in a vacuum. And the ripple effects that may result from shoring up these giants extend from the obvious -- hammering their shareholders -- to the fairly obscure, involving participants in the market for credit default swaps.

This is the huge arena where participants buy and sell insurance to protect against defaults by issuers of debt. Some $62 trillion of insurance has been written, with a fair value of $2 trillion at the end of 2007.

Back to the bailout du jour. Many analysts hypothesize that the Treasury will put cash into Fannie and Freddie, receiving dividend-paying preferred shares in return. Such an investment has occurred before, as noted last week by UBS research analysts in Mortgage Strategist, a weekly research report from the firm. In 1954, when the government began to change Fannie Mae into a shareholder-owned company, preferred stock was issued to Uncle Sam to help finance the process. Those shares were retired in 1968 when Fannie Mae became a publicly traded corporation.

If preferred shares are again issued in exchange for taxpayer cash, common stockholders could lose the most because new preferred shares would take precedence in the payment of dividends and if the companies were liquidated.

Investors holding the preferred stock already issued by Freddie and Fannie could also be vulnerable if the bailout puts the taxpayers' investment ahead of them for dividend payments. Regional banks and savings and loans hold most of these shares; with these institutions already hurt by the mortgage mess, it seems unlikely that the Treasury would structure a Mac 'n' Mae rescue in a manner that would pound them again.

But the potential effects of a rescue become more complex for the holders of Fannie's and Freddie's $19 billion in subordinated debt, so-called because it ranks below other bonds in the companies' capital structures.

As UBS analysts point out, because Fannie's and Freddie's subordinated debt is used when they calculate capital -- the financial cushion regulators require to support the companies' operations -- interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.

While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a "credit event."

On its Web site, and in language that only a lawyer could love, Fannie Mae describes some terms of its subordinated debt. For the debt to qualify for capital calculations, it must require the deferral of interest payments "for up to five 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 percent of critical capital."

Here's a translation: A bailout could mean no interest payments on the subordinated debt.

"If we reasonably assume that the Treasury would only intervene in the event that Fannie or Freddie is declared significantly undercapitalized by its regulator," UBS analysts wrote, "then interest payments on the qualifying subordinated debt is automatically deferred for up to five years."

Because nonpayment of interest would be seen as a credit event, UBS added, entities that have bought protection on Fannie's and Freddie's subordinated debt would be entitled to payment by the entities that wrote the insurance. This, even though taxpayers are standing behind Fannie's and Freddie's debt, not allowing it to fail. Talk about the laws of unintended consequences.

It is not clear how much insurance has been written on the subordinated debt. The actual holders of the debt very likely hedged their stakes with credit insurance, which is intended to protect buyers in the event of a default.

But speculators may have bought credit default swaps on the companies' subordinated debt even if they did not own any of the debt. A gutsier gamble than selling short Fannie or Freddie shares, buying credit insurance on the companies' debt was essentially a bet against the implicit government guarantee that many felt was backing all the companies' obligations.

Because of the implied guarantee -- and the belief that it meant they would never have to pay out on the swaps -- sellers of credit insurance may have been overly eager to write contracts on Fannie's and Freddie's debt.

So the burning questions are these: Who wrote the insurance and do they have the money to pay those who bought it? If they don't, what happens?

If the market for credit insurance were more transparent, we might know the answers. But these deals are private and largely hidden from view.

It is possible, of course, that a Mac 'n' Mae bailout will be structured so as not to force credit default swap payouts. Or regulators could step in and require parties on both sides of the Fannie and Freddie credit insurance trade to unwind their stakes at heavily discounted levels. Such has been the nature of recent deals struck by financial guarantors like Ambac at the behest of the New York State Insurance Department. In one deal, the credit default swap buyer got just 13 cents on the dollar; in another deal, the buyer got 61 cents.

If regulators make such a move related to Fannie and Freddie, sellers of the insurance could escape dire financial problems associated with paying on the claims. But buyers of credit protection are apt to get far less than they think they are owed on the insurance. And if they have written the values of their holdings way up to reflect the increased likelihood of a default event, they will soon have to write them down again.

Nobody knows how the Fannie and Freddie situation will play out. But the implications of a default on the companies' subordinated debt shows how complex and confounding -- not to mention costly -- this business of bailouts has become.

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