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5.2 the collapse of freddie and fannie and the

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Unformatted text preview: 5.2 The Collapse of Freddie and Fannie, and the Conservatorships 5.2.1 Early Warning Signs With nationwide housing markets collapsing, a deep recession, and an increasingly risky mortgage portfolio, the GSEs showed their first losses in 2007. The combined $5 billion loss was due to credit-related expenses of $8 billion. In early July 2008, three months after the mortgage-related collapse of Bear Stearns and with the stock market down 20% from its peak, speculation was rampant that the government would have to rescue Freddie Mac and Fannie Mae – at least in terms of their obligations to their creditors. By then, the GSEs had already lost an enormous amount of stock market capitalization. In 2007, Freddie’s share price fell by 50% from $64 to $32, while Fannie’s stock lost 36% of its value. By July 1, 2008, Freddie’s stock had dropped by another 50% to $16. Doubts about the future of the GSEs plunged Freddie’s share price a further 50% to $7.70 on July 10. In the first week of September, the stock traded at $5.10. Fannie’s share price dropped from $27 to $21 over the first half of 2008. Over the summer of 2008, it fell further to $12.60, just prior to the conservatorships. Clearly, the stock market anticipated much worse times to come for the GSEs as early as the fall of 2007. It started anticipating a rescue for creditors in 66 June-July of 2008, with little residual value for equity holders. In all, $60 billion in market capitalization was lost between October 2007 and early September 2008. Bond markets also spelled early signs of trouble. The difference in yield between the debt of 5-year Fannie Mae debt and 5-year Treasuries rose sharply from 0.2% per year at the end of 2006 to 0.4% in September 2007, and to 1.0% in September 2008. This increase in yields reduced the value of widely-held GSE debt. In addition, the GSEs were forced to issue shorter- term bonds in the second half of 2008. The cost of insuring against a default on the bonds issued by the GSEs also started to rise. The CDS spread for Fannie Mae was a low 6 basis points in December 2006 and rose to an all-time high of 88 basis points in March 2008. While noticeable, this 82 basis point increase in CDS spreads pales in comparison to the 500 basis point increase in the CDS spread for Bear Sterns or for Lehman Brothers just prior to the latter’s bankruptcy. This difference reflects the market’s belief that the government would likely bail out the bond holders of the Fannie and Freddie, but not the bondholders of the investment banks. Indeed, this belief turned out to be correct ex-post when Fannie and Freddie CDS contracts were settled at prices near par. Ironically, although Fannie and Freddie were clearly getting close to extreme financial difficulties, their regulator FHFA could not do much about addressing their imminent troubles since the regulator’s most recent semi-annual regulatory exams had not cited capital shortfalls....
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5.2 The Collapse of Freddie and Fannie and the...

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