Heard on the Street
Freddie and Fannie Bonds Don't Share and Share Alike
By John Carney
June 23, 2014 5:20 p.m. ET
A specter once thought exorcised from the housing finance market may be haunting it once more: the "implicit guarantee."
That describes a peculiar belief that existed before the financial crisis, when it was widely assumed that Fannie Mae and Freddie Mac would be rescued by the government if they fell into distress. Despite evidence that this idea enabled the two companies to borrow at interest rates close to Treasury yields, government officials denied any such guarantee existed-right up until they rescued the mortgage giants in 2008.
Now it looks like that belief endures, with risks for investors, regulators and taxpayers.
Unlike traditional mortgage-backed securities, these bonds don't have any collateral backing them. Instead, they are synthetic, with payments linked to how the relevant mortgages perform. As mortgages go bad, the amounts due to bondholders can shrink.
The bonds sold terrifically well and have made money for initial investors as their price has risen.
The yield on Freddie's triple-B rated bonds was recently less than one percentage point above the London interbank offered rate, or Libor, a benchmark interest rate, according to Wells Fargo. The spread for Fannie's triple-B bonds has narrowed to 0.67 percentage point.
These yields are now much tighter than most other classes of similarly rated securities. For example, investors could pick up an additional 2.5 percentage points of yield by buying similarly rated bonds backed by auto loans, Wells Fargo notes.
While good news for those who bought the Fannie and Freddie securities, it may not be for taxpayers. Those ultralow yields may undercut the very rationale for these bonds.
After all, the bonds—Freddie's are called "Structured Agency Credit Risk" securities, Fannie's are "Connecticut Avenue Securities"—are officially "credit-risk sharing" instruments. They are meant to transfer some of the risk of default on the underlying mortgages to investors. That should make them less likely to draw on the hundreds of billions of dollars in taxpayer funds committed to supporting the mortgage giants.
Yet the low yields suggest investors don't believe very much risk is being transferred at all.
Perhaps they think the bonds are just safer bets than the triple-B ratings indicate. That would mean, however, that the bonds aren't really measuring investors' appetite for default risk and aren't meaningfully lowering the risk held by the mortgage giants.
Another explanation is more disturbing: Investors may believe that Fannie and Freddie would support the bonds even if the default triggers were tripped. The bond terms would allow Fannie and Freddie to reduce payments, but there is nothing that would legally prevent the two companies from unilaterally waiving payment reductions, effectively bailing out bondholders.
The companies would have an incentive to do so. Allowing a credit event to reduce payments to investors might snuff out interest in the bonds altogether.
The tax section of the bond documents suggest there isn't much risk of bondholders not getting paid. The companies both expect that payments under the bonds will be favorably treated as "qualified stated interest" payments, because the likelihood of reductions in amounts owed to investors is so "remote" that they can be considered unconditional payment promises.
While existing bondholders may enjoy the notion of an implicit guarantee, prospective investors and regulators should be wary that history may be repeating itself. At the very least, there is reason to doubt that these bonds have made Fannie or Freddie significantly safer from mortgage defaults.
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