Saturday, August 23, 2008

Fannie and Freddie Preferreds Could Cause Bank Failures

Honestly, this is all so awesome in some horrible way.

I understand that dealing in schadenfreude is a dangerous game, but really, was this so hard to see coming?

This excellent Washington Post article from today's paper talks about the fact that the preponderance of the $36 billion of Fannie and Freddie preferreds issued in the past year are in either foreign hands or are owned by US banks!

Yes, you read that right. US banks, in the midst of the worst housing crisis since the 1930s, bought billions of preferreds from FNM and FRE despite knowing that both GSEs were suffering enough problems that they needed to recapitalize! Further, the problems Fannie and Freddie are suffering from that caused the need to issue preferreds are housing banks really need to take more US housing market risk? Why add super-levered and super-correlated housing risk to your already troubled balance sheet?

Despite the fact that these preferreds were A rated pieces of paper, the real calculus is this: Fannie and Freddie are massively levered (depending on how you calculate leverage, somewhere between 40:1 and 100:1). That leverage is basically collateralized by mortgages with initial LTVs of somewhere between 20% and 10% as well as a good chunk of third party issued ABS that the GSEs bought for investment purposes (oops!). Freddie and Fannie both had very slim equity cushions supporting the preferreds at the time of issuance and that equity is basically entirely comprised of mortgage/housing related risk.

So, for purposes of this analysis, we can imagine that if FNM and FRE equity (the publicly traded stock) is in the "first loss" position on housing defaults, the preferred is right behind it (second loss), with the US government in the larger "third and final loss" position via its increasingly explicit guarantee of GSE guarantees. Thus, the preferred is much more risky than a diversified pool of mortgages with 20% equity that a bank might typically own, though the preferred holders are compensated by some modest extra yield. Unlike the preferreds, a diversified pool of mortgages represents the entire capital structure of a home behind the owner and any mortgage insurance. So to the extent a bank ties up $500 million of capital in said diversified pool of mortgages, the odds of losing much of it are fairly low. A 5% loss on the pool equates to a $25 million loss to the mortgage holders.

However, by being in the second loss behind the equity in FNM and FRE via the preferreds but in front of $5 or $6 trillion of other folks, the risk of losing a lot on that investment are much, much, much higher. Your $36 billion preferred is less than a 1% sliver in that $5 trillion stack! That relative "thickness" (or, in this case, thinness), is key when compared to the absolute thickness of retaining 100% of a diversified pool of mortgages. The ability to lose your money happens so fast in the preferred that it is basically binary: you either come out whole or lose all your money. That is not the business that traditional banks normally operate within. Given that a bank's own capital structure is already levered 12:1, binary outcomes on large investments are anathema to solvency.

In fact, to the extent that the diversified pool of mortgages is representative of the mortgages FNM and FRE touch, you can imagine that just a small but fast single digit loss on the pool of mortgages may equate to a total wipeout of the equity and the preferreds of the GSEs.

That negative leverage seems to scream to me: Danger, Will, Danger!

It stuns me that folks were still "reaching for yield" from two entities positioned near the eye of the storm while the hurricane was already apparent, gaining strength, and heading for landfall. It is as if a homeowner in New Orleans, on the eve of Katrina, offered All State a little extra premium in order to insure his or her home against a hurricane. Under no circumstance short of enormous premium would All State take that risk and even then, I doubt they'd do it.

But regional banks?

No wonder these banks are all in trouble - they are run by folks that do not understand risk. They literally believe that buying a FNM or FRE A-rated preferred (while the GSEs were already in trouble, so the risk was not exactly a secret) has a similar risk profile to making actual mortgages.

Sadly for the US banking system, on Friday Moody's downgraded all $36 billion of preferreds from A1 to Baa3 (which is kind of like "BBB-" or the lowest investment grade rating). That is a very bad event from a mark to market and a capital requirement standpoint for any banks that own these securities (e.g., Regions, M&T, Astoria).

Those also happen to be banks that don't exactly have capital to spare, due to their own lending struggles.

Strap your boots on.

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