Part 3 – Impact on the Financial Markets?
Recap of Part 2
Part 2 discussed the course of events that led to the Fannie Mae and Freddie Mac bailouts; part 3 will cover what impact the bailouts have had on the financial markets.
The market’s belief that there existed an implicit guarantee that Agency securities would be bailed out in the event of a technical default was validated when Fannie Mae and Freddie Mac were brought into conservatorship. This provided an additional level of assurance to the markets that the risks of Agency securities were only slightly higher in relation to Treasury securities. Figure 1 below shows the Agency security option adjusted spread (OAS) which is the difference in yield between an Agency security and a comparable Treasury security; this essentially demonstrates how much additional yield investors require (and the assumed level of risk involved) to invest in an Agency security. The spread of Agency securities over Treasuries quickly rose to over 1.5% in 2008 at the peak of the crisis, before declining down to approximately 0.20% in 2011, indicating the market believed the riskiness of Agency securities had declined after the “bailout”.
The TED spread in Figure 2 shows the difference in interest rates on three-month contracts for interbank loans (Eurodollar futures) and three-month futures contracts for United States Treasuries. The TED spread is commonly used as an indicator of credit risk in the overall economy. United States Treasuries are considered risk free while the interest rates on Eurodollar futures are believed to contain the borrower’s credit risk. Figure two supports the conclusion from Figure 1 that the bailout had changed the market’s perception of the risk in investing in the banking industry.
Who are the stakeholders and beneficiaries of the bailout? Investors with substantial exposure to Agency securities included local municipalities and state governments whose investment policy statements (IPS) restricted them to buy only United States Treasuries and Agency securities. Foreign investors and global Central Banks had significant exposure to the Government Sponsored Entities (GSEs) due to their perceived safety. If the Federal Government had let Fannie Mae and Freddie Mac become insolvent, city and state governments would have seen unrealized losses. The value of Agency securities were declining up to the “bailout”, putting a strain on government reserves and operating cash. Secondly and even more critical, if foreign investors feared insolvency, many of these investors would most likely sell current assets and move them to other securities, most likely putting downward pressure on United States Treasuries, Agencies and the United States dollar.
This second point is particularly important as the United States is a debtor nation (we continually run a budget deficit) and consequently we rely on investors in foreign countries to finance our national debt by buying Treasury securities. A substantial proportion of outstanding Treasury and Agency securities are held by foreign investors and central banks. As the financial crisis began and discussions regarding a potential bailout took place, pressure from foreign investors in favor of a bailout undoubtedly surfaced. If the bailout had not occurred and the foreign investors had pulled their investments from Treasury and Agency securities several undesirable results were probable:
- Borrowing costs in the United States may have risen substantially as the availability of financing became restricted
- The United States economy may have fallen into a more severe recession than we had experienced with the bailout
- The United States dollar would likely have depreciated relative to our trading partners
Critics of the bailout point out the large amounts of money spent to resolve issues caused by carelessness and irrationality. However, even if the bailout had not occurred, the economic impact of increased borrowing rates and reduced economic activity would most likely have prompted additional reaction from the Federal Reserve. We will never know for certain what may have happened had the bailout not occurred, however as a result of the bailout both United States Treasuries and Agencies can maintain their perceived safety which allows the United States unparalleled flexibility in raising funding internationally. At this time, the United States Government has recovered their investment in Fannie Mae and Fannie Mac. How and when conservatorship will end and the role Fannie Mae and Freddie Mac will play in the housing market is in the hands of Congress.
Thank you for following along for all three parts of the Government Bailouts series. I hope that this series provided you with a better understanding of the bailout of Fannie Mae and Freddie Mac and the economic factors impacted by the bailout decision.
William Cox, CMA