FYI | Sep 08 2008
By Chris Shaw
The US government has finally moved to restore some credibility and confidence in its financial markets by announcing the Federal Housing Finance Authority would take on direct oversight of mortgage groups Fannie May and Freddie Mac via a conservatorship system which entails the issue of US$1 billion in senior preferred shares in both companies to the government.
As ANZ Banking Group head of foreign exchange and international economics research Amy Auster notes, the move was designed to do three things – restore the market’s confidence in the solvency of both companies, restore the market’s confidence in the mortgage market as a whole and to try to bring down mortgage rates.
Auster suggests the immediate objectives have been met by the move, as US equities rallied on the news and US Treasuries were sold-off as “flight to quality” pressure eased. The view of a positive outcome from the move is shared by Goldman Sachs, with the broker noting the decision to support both companies will be positive, as it removes some systematic risk and the economic tail risk of an even deeper contraction in the housing credit market.
In the broker’s view, the treasury market’s reaction is likely to be positive with respect to high quality spread products, while it is also expected to provide a boost for both financial stocks and broader equity risk in the shorter-term at least.
According to Goldman Sachs, the decision is unlikely to impact on Federal Reserve rate policy but where it could impact is on expectations of how quickly the Fed moves to normalise rates in coming years from what are accommodative levels at present. Assuming the market looks at things the same way, the broker expects the front end of the rate curve will receive the strongest support.
One concern of many in the marketplace has been the cost to the US government of the bail-outs of recent months, but on Auster’s figures, the cost is unlikely to be excessive. She estimates the total direct and indirect cost to the public sector from the credit crisis at around US$123 billion, which compares to the 1989 Savings & Loan crisis where more than 1,000 institutions holding more than US$500 billion in assets were forced to close.
While these are the positives, Goldman Sachs notes the one thing that hasn’t changed from the bailout decision is the fact the US housing market remains in a serious slump and the financial system itself is still damaged, meaning the move won’t simply change the global outlook overnight even if it does provide a temporary boost for equity markets and confidence levels.
According to US broker BTIG’s chief market strategist Mike O’Rourke the government’s decision to bailout the two companies was no surprise, as there was no way they were going to be allowed to fall over. Although, he points out, the decision means existing shareholdings are being significantly diluted in return for knowing the companies will continue to have at least some value.
The most important part of the plan, in their view, is the attempt to reduce systematic risk. This starts with the requirement, in 15 months time, for each company to cut 10% of its retained portfolio until they are each reduced to US$250 billion.
The broker suggests this may cause some problems for financial institutions holding Freddie & Fanny preference shares as part of their core capital, but here the Treasury says it will attempt to be as supportive as it can. With some selling likely to hit the market, it argues while longer-term the US economy and stock market will both be better off under the plan, there is likely to be some pain in the next couple of years as the overhangs slow the pace of any recovery.
Short-term, the group notes US equity futures are higher, as the cleaning up of another mess helps with investor confidence. It remains a trading market though, as what has happened is not enough to create a true market bottom. Consumers are still stretched and the economy continues to face difficult conditions, while for equity prices generally, the earnings disappointments that began in the financial sector are now showing signs of spreading further across the market.
