WASHINGTON — A move by the Federal Reserve Board to pump $200 billion into the markets by lending Treasury securities in return for collateral including agency mortgage-backed securities is seen as strengthening the implicit government guarantee of Fannie Mae and Freddie Mac.
Though senior Fed staffers insisted the plan was aimed at stabilizing the market — not specific firms — it gives the government-sponsored enterprises critical support at a time when market turmoil has left debt and equity investors questioning the companies' underlying health, observers said Tuesday.
"The government is going to strengthen its implicit guarantee despite the fact that, as we know, this administration and the Fed have not been very favorably disposed toward Fannie and Freddie," said Alan Blinder, the former Fed vice chairman who now holds that title at Promontory Interfinancial Network. "But in this situation, I think those attitudes are in the process of being reversed. You can think of the Fed's action as one step in that reversal."
Arun Raha, the vice president and senior economist at Swiss Re, agreed.
"The Fed's backing them now. That they're willing to accept … [agency MBS] as collateral means they're making them more liquid."
An industry source familiar with the GSEs, who spoke on condition of anonymity, went further, calling the Fed's move a "stealth bailout."
"They are directly supporting those two companies," the source said. "It's very positive for Fannie and Freddie."
A spokesman for Freddie said Tuesday that it applauded the Fed's move. "We believe it is a positive step that will provide much needed liquidity to the market."
The Fed did not comment on whether its actions benefited the GSEs, and a spokeswoman for the Treasury Department reiterated the administration's position that the government does not stand behind the GSEs.
But various sources said it had become clear that some kind of action was needed to stem growing problems at the GSEs. In the past week hedge funds began selling off agency paper, and a Barron's article over the weekend alleged the government could soon be forced to rescue Fannie.
Shares of the GSEs fell to 52-week lows Monday. But after the Fed's announcement Fannie's stock rose 11% Tuesday, to $22, and Freddie's rose nearly 16%, to $20.16, on a day when the market rose 3.55%.
The Fed said in the morning that it would lend Treasury securities to 20 commercial and investment banks in return for a broader set of collateral, including agency mortgage-backed securities.
The step followed one Friday to inject $200 billion through cash auctions and repurchase transactions, and was taken in conjunction with similar actions with four other foreign central banks.
The staffers conceded the move exposes the Fed to more risk, but they tried to downplay it with several qualifiers.
First, the Fed is accepting only triple-A-rated MBS that is not on a watch list for a downgrade, they said. A haircut on collateral will be imposed, they said. (As of Tuesday that formula had not been set.) The securities will be priced daily, and the staffers noted that the counterparties are all companies with which the Fed has had extensive experience.
The Fed said it will conduct weekly auctions beginning March 27. The contracts will last 28 days and can be rolled over.
Among the questions facing Fannie and Freddie is their asset quality, especially when debt once considered to be high-quality is producing losses.
Downgrades are already evident at Freddie — 99.8% of its single-family asset-backed securities portfolio carried triple-A ratings at the time of purchase. By Feb. 25 that ratio had declined to 85.7%, according to Freddie's analysis of its ABS portfolio released last month.
Still, the GSE maintained that the downgrades would not lead to substantial long-term losses.
"Freddie Mac believes that the unrealized losses on the ABS portfolio as of Dec. 31, 2007, are principally a result of decreased liquidity and larger risk premiums in the subprime market, and has not identified any bonds in the portfolio that are probable of incurring a contractual principal or interest loss," according to the analysis. "As such, and based on the company's ability and intent to hold these securities for a period of time sufficient to recover all unrealized losses, we have concluded that the impairment of these securities is temporary."
In its 2007 annual report, Fannie said all of its private-label mortgage securities backed by alternative-A loans were rated triple-A and none had been downgraded. Still, it acknowledged that since yearend 4% of those securities came under review for a possible downgrade.
Most observers agree the biggest threat facing the GSEs is credit risk as the housing market continues to weaken.
"Until recently we thought it was interest rate risk that was the biggest potential problem, but with the current environment of falling house prices, it's the credit risk at the moment that looks like the bigger problem," said Lawrence White, a professor at New York University's Stern School of Business.
Karen Shaw Petrou, the managing director of Federal Financial Analytics Inc., said the companies run the risk of uncertainty spiraling in panic.
But she said the Fed's action Tuesday could protect Fannie and Freddie. "If this finally works, then it may help to ease the margin calls, ease some of the pressures on the hedge funds, which will ease the strains on Fannie Mae and Freddie Mac," she said.
Regulators at the Office of Federal Housing Enterprise Oversight said Tuesday that both Fannie and Freddie were "adequately capitalized" as of yearend.
The agency said Fannie held a 9.3% surplus over OFHEO's required capital level and Freddie reported a 10% surplus.
The GSEs' implied guarantee from the government has been a source of controversy for years. Treasury and Fed officials have emphasized repeatedly that the two GSEs are not backed by the government, but foreign investors, who buy much of the two companies' debt, perceive the opposite. Their belief springs from the fact that the GSEs are congressionally chartered organizations, hold a $2.25 billion line of credit with Treasury, and are generally thought to be "too big to fail."
That implicit guarantee has greatly benefited the GSEs, particularly as other parts of the market have seized up and investors have fled to agency debt.
But growing doubts about the financial conditions of the GSEs fueled rumors late last week that Treasury was on the verge of explicitly backing the GSEs' debt — an action that would reverse decades of official government policy. The Fed's move, while less dramatic, nevertheless reinforces the idea that the government sees agency debt as a safe investment — something that could reassure wary investors.
