Is it a coincidence that a week after the ban on naked short selling on Freddie Mac and Fannie Mae that both are now back under pressure?

Very soon, the US Government will be forced into some sort of bailout. It is coming, very quickly, and the sharks in the credit markets sense that.

It’s probably why US dollar short term interbank rates in Europe persist well above the 2% Federal Funds Rate and 2.25% Fed discount rate. There seems to be a growing fear that another big financial group is having problems.

Fannie and Freddie are the most obvious candidates, after the events of the past three days. The duo have more than $US200 billion in debt that has to be rolled over or repaid by the end of next month. It won’t happen without them paying huge premiums on the debt, which in turn will force up mortgage interest rates, further hurting the depressed housing and finance sectors, and triggering more foreclosures. All of that six weeks out before the US Presidential poll.

An auction of Freddie debt yesterday exposed this potential explosion: Freddie sold $US3 billion in new debt, but at a margin of 1.13% over the equivalent US government debt rate. These were five year “reference notes” and the premium means that the hard heads in the credit markets believe that these quasi-government companies are increasingly risky.

It had been expected that after the passage of legislation through the US Congress formalising the US Government plan to support them, that the debt premiums would gradually settle down. Far from it and the news of the premiums saw Freddie and Fannie shares hit their lowest levels in nearly 20 years, dropping below the levels they bottomed out at last month in the panic that led Treasury Secretary Henry Paulson to propose government-funded “support” that later became law when approved by Congress.

So while the US Securities and Exchange Commission ban on naked short selling helped stabilise the market and that legislation was put through the US Congress, the deeper problems at Fannie and Freddie are still there for everyone to see.

The ban expired on August 12 with the SEC promising new rules on short selling as soon as possible. I reckon those rules will appear very quickly after the shares of both lumbering giants were attacked on Monday, Tuesday and overnight in US markets. On top of this, there seems to be a change of emphasis in the US Government towards supporting both groups.

But it’s not just the shorts who are causing them pain: the credit markets just don’t believe the two when they argue they are well capitalised and investors seem to be challenging the US Government to intervene and back them directly.

According to Bloomberg, Fannie and Freddie have $US223 billion of bonds due by the end of this quarter and their success in rolling over that debt may determine whether they can avoid a bailout. Fannie has about $US120 billion of debt maturing between now and September 30, while Freddie has an estimated $US103 billion.

If these bonds can’t be rolled over, then the government will have to step in with support; if they are rolled over, payment of premium rates of 1% or more will turn the housing sector into a bigger disaster area. In July Fannie and Freddie did almost 100% of the refinancing of less than $US100 billion in mortgage debt. The private sector has runaway to hide and the big US banks and other lenders are cutting back every day by raising their lending standards, and seeing more and more defaults among high quality prime home loans.

Unless there is a dramatic turnaround in sentiment, judgement day is approaching rapidly for Fannie, Freddie and the US Government.

The optimists are those who continue to own the shares, which have tanked. They have no value whatsoever.

Peter Fray

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