US: Fed and Treasury Take Action on GSEs

Daily Forex Fundamentals | Written by Danske Bank | Jul 14 08 11:38 GMT |
Overview:

Late last night both the Federal Reserve and the Treasury issued statements granting more explicit support for Fannie Mae and Freddie Mac. The initiatives involve extended liquidity provision by the Fed and the Treasury, as well as a temporary authority for the Treasury to inject capital into either of the two Government Sponsored Enterprises (GSEs) if needed.

The action comes on the back of a period of increasing uncertainty about the access to liquidity and the capital adequacy of the two largest mortgage lenders in the US. Generally, the action should be seen as a move to avoid a liquidity squeeze for the two lenders, which would have a further destabilising effect on the financial markets and more generally on the US housing market. Further, yesterday's move proves the de facto government guarantee extended to the GSEs.

Details: The main initiatives are:

1) The Federal Reserve has opened the Discount Window for Freddie Mac and Fannie Mae. Through the Discount Window, the GSEs can access liquidity for up 90 days by pledging eligible collateral.

Federal Reserve press release

2) The Treasury has proposed a three-step plan:

a. As a liquidity backstop, the plan includes a temporary increase in the GSEs' line of credit with the US Treasury. The Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

b. To ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for the Treasury to purchase equity in either of the two GSEs if needed

c. To protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards.

The plan is expected to be fast-tracked through Congress later this week to take immediate effect.

Paulson's statement on GSE initiatives
Assessment & Outlook:

With yesterday's action, the US government has shown its determination to prevent a failure of any of the two GSEs. Fannie Mae and Freddie Mac together hold or guarantee around half of the outstanding mortgage debt in the US and have been key players in the Government's recent efforts to stabilise the housing market.

If the GSEs were to fail or lose their triple A ratings, it would have large ramifications for the US housing market and financial markets in general. That said, the latest move by the Federal Reserve and the Treasury does little but confirm the well-known implicit guarantee extended to the GSEs. Given that the GSEs are now more explicitly backed by the US government and the Federal Reserve, they should be able to access sufficient capital to continue their usual operations. Hence, yesterday's move should not impact much on he general outlook for the US housing market.
Financial markets:

In the US bond markets, yields jumped sharply already Friday night in anticipation of a move by the Treasury. Over the weekend, 2Y and 10Y Treasury yields touched highs of 2.69% and 4.03%, respectively, before edging slightly lower this morning. The jump in Government bond yields seems to be driven partly by a short-term knee-jerk reaction reflecting relief in other parts of the market over the Government action and partly by a more long-term concern that the Treasury's involvement could lead to an extension of Government debt. If the Treasury were to inject a substantial amount of capital into the GSEs, this could in turn add a higher risk premium to Treasury bonds.

If anything, the recent turmoil has made expectations of an imminent Fed hike look even more stretched. The market is currently pricing a full 25bp hike by December. While day-to-day volatility in the bond market will remain high, we continue to see a potential for lower bond yields and a steeper curve over the coming months.

In the currency markets, the dollar has been pushed weaker. The greenback is hypersensitive to financial distress, and with oil prices still setting new records, this combination is certainly not helping the already stretched currency. EUR/USD was trading around 1.57 before nervousness on Fannie Mae and Freddie Mac struck the market but took off by the end of last week. In the Asian session this morning, the pair has reached a new local high of 1.5971, reminding the markets of the April 22 all-time high of 1.6018. The pair has, however, fallen a little in European trading. We do not see any quick solutions to the dollar decline. The US is still the main provider of the flow of bad news, although European markets are starting to show worrying signs as well. The financial crisis is still weighing mostly on the dollar relatively to the euro, and the economic slowdown is unfolding at a faster pace across the Atlantic. Furthermore, risks of diversifying international reserves away from dollars and rumours of dollar de-pegging persist in the market. We expect EUR/USD to remain at elevated levels over the coming months. Our 3M forecast of 1.60 underlines the continued pressure on the dollar due to the US economic slowdown and continuing financial turmoil.

Danske Bank