Government takeover leaves previous shareholders out in the cold, but American households will benefit from lower mortgage rates.
The U.S. government moved decisively over the weekend to secure the ongoing operations of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, in a complete government takeover of the entities, with the previous executive management of the company blown out the door and the Federal Housing Finance Authority taking control. The capital structure of the GSEs will see a radical restructuring, with the Treasury taking $1 billion in preferred shares in each entity and also receiving warrants on 79.9% of the common stock. The Treasury also created a new credit facility of secured loans, and pledged to provide up to an additional $200 billion in capital if necessary. With several bold strokes, the Treasury effectively has taken the solvency issue of the GSEs off the table.
By eliminating the dividends on existing common and preferred stock, and raising unanswered questions about the long-term future of these two entities, however, the shareholders are being left out in the cold—the common and preferred shares will take a big negative hit today. Moreover, the Treasury's move does not answer the question of what ultimately happens to the GSEs—management control goes to the regulator, but the next Congress will ultimately have to decide on their long-term role in the mortgage markets.
While the takeover is bad news for exiting shareholders, it will be good news for American households who are either looking to purchase a home for the first time, or refinance their existing mortgage. Since August 2007, we have seen a general upward trend in GSE funding spreads, with periodic spikes of higher amplitude. With this takeover, the implicit guarantee of the government on GSE debt becomes more explicit, and we should see a significant decline in GSE funding spreads. Our best guess is that funding spreads could drop by 40–50 basis points from average levels of about 80 basis points on 20-year debt in the past six weeks.
Combine that with recent declines in Treasury bond and note yields, and there is a very high probability that 30-year fixed-mortgage rates could move down to close to 6% within weeks, and possibly drop below that level by the end of 2008.
The prospective decline in mortgage rates should provide a needed shot in the arm to the U.S. housing market, as it would provide another boost to affordability beyond the sharp declines in prices that we have seen in the past two years.
However, the takeover move instantly creates further mark-to-market losses for holders of GSE common and preferred stock, and will shoot another hole in the severely battered hull of financial system capital. This impact has to be weighed against expected mark-to-market gains on $5 trillion in outstanding GSE debt and guarantees—which could well be substantial. How these competing effects will play out in the markets and the economy is difficult to say, but the net impact on financial sector shares is expected to be positive in the short-term.
With substantial pending declines in mortgage rates in the pipeline by the end of 2008, there may be a glimmer of upside risk to the U.S. housing outlook for the second half of 2009.
