The latest debacle at Fannie Mae is perhaps the deadliest in its existence as a Government Sponsored Enterprise (GSE). The latest discoveries by the Office of Federal Housing Enterprises Office (OFHEO) could ignite a firestorm that may result in dramatic makeovers at the very heart of the organization. As a corporate treasurer, should you sell your Fannie Mae bonds or should you buy more because the yields are higher? Should you be oblivious of the financial headlines if your goal is to hold your investments to maturity?
Stay the Course: Investors are rightfully concerned with the latest development at Fannie Mae, given the sizable holdings of the triple-A rated agency debt in many bond portfolios. For corporate cash accounts, we have been advising to stay the course in holding agency debt with maturities less than three years. Earmarking for unexpected cash outlays and the intent of minimizing marked-to-market losses may suggest lesser allocations to GSE bonds of longer maturities. In a nutshell, we believe that there is no strong fundamental credit basis to support an outright retreat from the very highly rated agency bonds solely based on the reported management mishaps at Fannie Mae.
The GSE debt issued by the likes of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, are an entirely different class of investments from stocks and subordinated bonds issued by the same companies. In fact, both Moody’s and Standard & Poor’s, two of the nation’s largest credit rating agencies, view the GSE status and their central role in the US government’s housing finance policy as the cornerstone of their agency debt ratings. It is conceivable that Fannie Mae could receive downgrades on its subordinated debt ratings, currently at Aa2/AA-, as the result of the findings, its public agency debt issuance and those of other housing GSEs should remain AAA.
To fundamentally weaken the credit paying ability of Fannie Mae would require an act of Congress to remove its GSE status. To date, even the harshest critics in Washington, and all proposed bills introduced, would not entertain such an idea. Based on the government’s experience handling the Farm Credit System crisis in the 1980s, we believe there is a very good chance that the existing debt holders would be paid in whole even in the very unlikely scenario that Congress took away the GSE status.
Too Big to Fail: What OFHEO uncovered merely confirmed the urgent need for further tightening the processes and procedures at the GSEs to minimize the “moral hazard” on the federal government. Critics have long claimed that Fannie Mae and Freddie Mac, with their quasi-government status and lower funding costs, built tremendous financial leverage on their balance sheets with mortgage portfolios. As of June 2004, the combined agency and mortgage debt issued or guaranteed by the two agencies alone amounted to$4.7 trillion, or 21% of all public and private debt outstanding in the United States. A failure or insolvency by either of the institutions could cause devastating effect on the housing finance sector and worldwide capital markets, and would require costly cleanup efforts by the government.
The OFHEO report detailed the preliminary findings at Fannie Mae, after eight months of investigation, that raised series doubts about the accuracy of GSE’s published financial results going back several years. We fully expect the report would accelerate the government’s effort to increase capital surplus with better command and controls, and more transparent financial reporting, at both Fannie Mae and Freddie Mac to further improve the safety and soundness of the entities. The GSEs may go through the process of extreme makeovers in the years to come. For now, at least, we believe they are too big to fail.
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Credit Risk
Treasury Inflation-Protected Securities (TIPS) Basics
What are Treasury Inflation-Protected Securities?
Treasury Inflation Protected Securities (TIPS), are inflation-indexed government bonds whose principal amount is adjusted periodically for inflation. A fixed interest rate is paid semi-annually on the adjusted amount. They may also be referred as Treasury Inflation-indexed Securities (TIIS).
Overview of the TIPS Market
Established in 1997 by the US Treasury, TIPS have grown rapidly into an integral part of the bond market. With almost $200 billion outstanding, TIPS allow the Treasury to broaden its investor base and diversify its funding risks, as well as supply the demand from investors to offer inflation protected securities. Liquidity in the TIPS market is improving, with daily trading volume nearly doubling in the past two years.
Key features of TIPS
The interest rate, which is set at auction, remains fixed throughout the term of the security. The principal amount of the security is adjusted for inflation, but the inflation-adjusted principal will not be paid until maturity. Semiannual interest payments are based on the inflation-adjusted principal at the time the interest is paid.
The index for measuring the inflation rate is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS).
The auction process uses a single-price auction method that is the same as that currently used for all of the Treasury’s marketable securities auctions. At maturity, the securities will be redeemed at the greater of their inflation-adjusted principal or par amount at the original issue.
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Peeling Back the Onion: Uncovering the True Risks of Student Loan Backed Auction Rate Securities
Moody’s Review for Downgrade and Fitch Rating Watch Negative:
AMS-3, 2003, LP, Class A-1 auction rate note (Aaa/AAA)
AMS-3, 2003, LP, Class A-2 auction rate note (Aaa/AAA)
AMS-3, 2003, LP, Class A-3 auction rate note (Aaa/AAA)
AMS-3, 2003, LP, Class A-4 auction rate note (Aaa/AAA)
AMS-3, 2003, LP, Class B auction rate note (A3/A)
Opinion Summary
In light of the current credit events and ratings actions surrounding auction rate securities (ARS) issued by Academic Management Services Corp (AMS), investors need to reassess the unique risk characteristics of this obscure security class. It is our opinion that current holders should strongly consider redeeming existing holdings issued by the same entity.
It is easy to dismiss the discrepancies discovered at AMS as isolated events unique to this servicer; however, we hold the view that scant disclosure, limited external oversight, as well as unfamiliarity of the investing public with this relatively new asset class, will likely contribute to more credit surprises in the industry.
Limited by the length of this commentary, we attempt to focus on just one of the risks associated with ARS investments, the structural risk. We seek to articulate why such a pristine triple-A credit rating on an ARS may not be as indicative of the true risk as one on corporate debt.
For a highlight of the other common risks associated with ARS investments, please refer to our publication “Seven Facts and Fiction About Auction Rate Securities”.
Background
Swansea, Massachusetts-based AMS is a unit of Texas issuer UICI that markets, originates, funds and services guaranteed student loans. It held $1.3 billion of student loans at year-end 2002, according to UICI’s SEC filings.
On July 21, 2003, AMS discovered a shortfall in the type and amount of collateral supporting two of the “securitized student loan financing facilities” by three of its “special financing subsidiaries.” In addition, all seven of its financing subsidiaries may have failed to comply with their reporting obligations. The former president of AMS was placed on leave and was relieved of all responsibilities.
Special financing subsidiaries are special trusts that allow a student loan originator to hold the assets legally separate from the parent organization for securitization purposes.
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