Thursday, September 11, 2008

Uh, Wait a Minute

“Wait, oh yes wait a minute mister postman
Wait, wait mister postman”
- Please Mister Postman (as performed by The Beatles)

Now that some of the dust has settled after the U.S. Government takeover of Fannie Mae and Freddie Mac, more details are coming to light.

In the most recent post on this blog, I stated that the implied U.S. guarantee of Fannie and Freddie obligations had become an explicit guarantee. Dumb ‘ol me: this is not the case.

In an article on Bloomberg.com published today (Sept 11th):

“The federal takeover of the government-sponsored enterprises, or GSEs, on Sept. 7 failed to address whether the debt of Fannie and Freddie should be included in the budget, or whether it carries an explicit government guarantee. In an interview this week, Treasury Secretary Henry Paulson cited the ``incongruities'' in the law and said ``we should be clear, is there a government guarantee or isn't there?''

Any decision to add Fannie and Freddie to the budget wouldn't automatically translate into an explicit government backing for the companies' combined $1.7 trillion in unsecured debt and $3.5 trillion of mortgage guarantees. Granting the full faith and credit of the U.S. would require an act of Congress to change the companies' legal status.”


As Emily Litella would’ve said “Ohhh, that’s very different!”

The perception in the market seems to be that the U.S. is on the hook for the obligations, no matter what might be said. Ever heard of “credit default swaps”? Commonly referred to as CDSs, credit default swaps are insurance for investors. If you own a bond say, and are concerned about getting your money back, you can buy an insurance policy in the form of a CDS. Like all insurance, the price is (for the most part) directly proportional to the likelihood of the insured event occurring during the time period covered, i.e., the more likely it is perceived the event will occur, the higher the price of the insurance.

You can buy CDSs on U.S. government debt. What you say? Someone out there thinks we might not pay? Yeah – someone out there thinks we might not pay and in fact, the cost of CDSs for U.S. Government debt has increased quite a bit this year. Ouch. If the U.S. is perceived as a lower quality borrower, that means lenders will require higher interest rates. Think of the implications of such a shift in perception for you and me as U.S. taxpayers: higher interest rates means higher federal outlays for debt servicing which translates into higher U.S. taxes.

Questions? kimm@sweetwaterinv.com

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