Fannie & Freddie Can’t Sell Their Debt

by REIT Wrecks on August 23, 2008

A few days ago, I was talking with a friend who until very recently had been in charge of capital markets at a privately-held “hard money” lender. Hard money is a rough and tumble world of last resort, where borrowers who are out of both time and luck go for quick cash, priced at prime plus ten and three points on closing.

My friend left because he refused to participate in a quiet, back-room shell game designed to conceal the true health of the firm’s loan book from their accountants and lenders. The scheme basically involved trading bad loans back and forth with competitors, then disguising the trades as repayments and refinancings. All they did was replace one piece of illiquid, rotting swamp sludge with another, but it made the companies and their portfolios look much healthier than they actually were.

While I found what he told me to be pretty disturbing, I dismissed the practice as a product of that particular environment, excacerbated by the fact that this firm was privately held. After all, Sarbanes-Oxley was written specifically to increase disclosure at public companies, and didn’t Andy Fastow and Jeff Skilling go to prison for falsifying financial records? And then Phil Bennett at REFCO after them?

So imagine my alarm when I read of similar financial contortions going on over at Fannie Mae, (FNM) and Freddie Mac (FRE). Foreign investors, particularly Asian central banks that had been huge buyers of Fannie and Freddie debt have pulled back in recent weeks, and that left Fannie and Freddie with no resort but to play “let’s make believe” with their debt sales last week.

In its online edition, The Economist wrote “Fannie, Freddie and Lehman ensure August is anything but quiet” that a five-year issue by Freddie Mac on August 19th sold for 1.13 percentage points over treasury bonds, the highest spread for at least a decade, and almost double what Freddie had to pay just a few months earlier. But extraordinarily high yields are only part what Fannie and Freddie had to offer.

According to The Economist, the banks that manage the agencies’ debt issues are pulling out all the stops to ensure their success, even to the point of artificially boosting demand through deals known as “switches”. In such an arrangement, an investor agrees to buy into a new issue in return for being able to sell back to the banks an equal amount of an old one, thus ensuring its net exposure does not rise.

If enough of these deals are struck, large amounts of debt can be shifted even when demand is thin. A recent $3.5 billion issue by Fannie was helped along by “very significant” amounts of switching, said one banker involved in it. With $223 billion, or one-seventh, of the agencies’ debt falling due before the end of September, those peddling it will have their work cut out for them, especially if the Asian investors continue to be put off by unkind headlines.

Fannie Mae and Freddie Mac are now clearly out of time and luck, and it looks like we taxpayers will soon become the hard money lenders of last resort. Bernanke signaled just such an outcome last week in Jackson Hole, and both common and preferred equity holders will soon be completely wiped out. Unfortunately, we have no choice. As The Economist wrote: “loss of faith in the firms’ equity is one thing, ebbing confidence in their vast pile of debt is altogether scarier.”

Disclosures: None at the time of this writing

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