Fannie, Freddie and Mispriced Risk

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Much of the focus of the media is on the start of the financial crisis beginning with the September 2008 problems of Lehman Brothers and American International Group (AIG).  Not forgotten, but usually not mentioned, was the dramatic event that occurred only a few days before -- the Federal Government placing Fannie Mae and Freddie Mac into receivership, a de facto nationalization of the two entities.  The primary reason for the government doing this, instead of allowing the companies to fail, was the perception of investors that the government stood behind the debt of these institutions -- the so called "implicit guarantee."

In hindsight, the implicit guarantee was nothing but a complete disaster.  The notion that the guarantee existed was surely not evident in the pricing of the bonds of these two entities. If it was evident, the spread between those bonds and U.S. Treasuries of like maturity would have been zero.  Nonetheless, there was a perception that the government stood behind Freddie and Fannie.  Many institutions and endowments developed a strategy to hold large amounts of Fannie and Freddie bonds in lieu of US Treasuries to take advantage of the modest increased yield with the advantages of the implicit guarantee from the US government.

The mess that these two entities created came when their equity structure could no longer support the losses of the firms.  Effectively, these were bankrupt entities, and if they were any other pair of institutions, the capital structure rules of the bankruptcy code would have determined the outcome of bondholders, preferred stockholders, and common stockholders.  The implicit guarantee made this outcome impossible, since many of the bond holders relied on the income stream from those bonds to pay for accrued obligations.  In short, it would have been chaos if Fannie and Freddie debt were to default and await resolution through the bankruptcy system.

The implicit guarantee was the problem.  Were Fannie and Freddie bonds allowed to operate without the implicit guarantee and be priced as a reflection of the strength of the underlying capital structure, many endowments and institutions would have shied away from the risk that would have been shown in the pricing of the bonds.

How TARP Has Ensured That We Have Learned Nothing

We have come to the point where Troubled Asset Relief Program (TARP) has become a major thorn in the side of banks throughout the nation.  The desire for government involvement in compensation schemes, lending practices, and corporate governance is a major issue for the competitive advantage for banks -- and taking part in the TARP Capital Purchase Program (CPP) has allowed the proverbial "foot in the door" for government control.  As a result, the banks cannot give back the TARP money fast enough to preclude any further government meddling.  

The terms of the TARP CPP are fairly onerous to banks.  The preferred stock that the CPP provides to banks comes with a 5% dividend yield to the government for the first 5 years, and then jumps to 9%.  This is cause enough for banks to want to return the TARP CPP preferred stock, with the overhang of impending government involvement adding to the sense of urgency.

Banks want to return the TARP money and American citizens generally want to exit the bank capital providing business.  Previously, banks had been offered a way to issue debt that was explicitly guaranteed by the government through the FDIC, where the FDIC was the insurer of these bonds. As a condition for TARP CPP repayment, banks must now demonstrate that they are able to raise debt without the backing of the FDIC in an effort to show they are capable of operating without government support.

Private Capital Raising: Too Big To Fail vs. Everyone Else

Exactly what does "too big to fail" mean?  The answer is fairly obvious: should these large institutions get into a situation where repayment based on the capital structure is not possible, i.e. a default on their bonds, then the government will step up and provide relief to these institutions in order to ensure that bond holders are unable to force the institution into a bankruptcy protection.

Effectively, the government is implicitly backing the bonds of the firms that are too big to fail.  This is an enormous competitive advantage when going to the private capital markets to raise capital, as the cost for funds of these too big to fail banks will likely be lower than it would be without the implicit guarantee.   Smaller banks that do not have this implicit guarantee will find it harder to raise funds in the capital markets and will likely be forced to further compromise their capital structure for the benefit of exiting TARP CPP.

Consider for a moment the predicament of a small bank who took TARP funding for only the reason to be "part of the solution."  People often forget, but after the September and October declines of last year, many people thought that involvement in TARP was a benefit for a bank; it was seen as confirmation to the public of the safety and soundness of the financial institution.  In order to pay that TARP CPP money back to the government, the small bank must raise private capital that it doesn't need, to replace the TARP CPP preferred stock that it didn't need, while being involved in an environment where credit availability isdecreased, and its national competitors are able to raise money with an implicit government guarantee that it does not have.

Mispricing Risk

It is important to differentiate between two types of capital that investors place in assets.  Roughly, this can be divided into two groups: speculative and safe.

Speculative investments are made with full knowledge that the investment may go to zero, and investors accept this potential fate as part of the decision to invest.  Safe investments, however, are seen as the investments that people want least exposed to loss.  For this they enjoy a lower return premium, versus the potential outcome of the speculative investment.  When an investment that was made with the intention of being least exposed to risk, turns out to be exposed to partial or total loss, it damages the psyche of the investors with respect to what is a "safe" asset.   As I mentioned earlier, many of the firms that held large amounts of Fannie Mae and Freddie Mac bonds were pension funds and endowments.  These firms surely did not want to expose their investment capital to loss, yet they sought to take advantage of the increased premium since the implicit guarantee was seen as a measure to guard against downside risk.

More importantly, we come to the situation with Fannie Mae and Freddie Mac.  The implicit guarantee allows for the mispricing of risk in the capital market for the debt of firms deemed too big to fail.  So the requirement for these large institutions to raise capital without FDIC backing as a condition to repay TARP CPP is disingenuous at best, and a willful charade at worst.  These large institutions have an implicit guarantee of the Federal Government due to their “too big to fail” status, and the correct pricing of risk as reflected in the yield demanded by investors is muted because of it.