Sunday, September 14, 2008

Fannie's & Freddie's Subordinated Debt

I witnessed an interesting exchange on CNBC last week between Pershing Square Capital hedge fund owner William Ackman and PIMCO's bond fund manager Bill Gross.

Ackman had just finished enumerating the points in his proposed plan to address Fannie's and Freddie's plights. Notable among his ideas were to convert some bondholder debt to equity, along with issuing long-dated puts for the equity. But Ackman stated that the subordinated debt was never meant to be guaranteed by the Federal government, as the products of the two GSEs were.

Gross spoke following Ackman and clearly expressed his belief that the principal of the subordinated debt of the two GSEs, of which his bond fund holds large amounts, was, indeed, guaranteed.

And that was the further subject of Thursday's lead Wall Street Journal editorial, "Bailout for Billionaires."

It's one thing, and appropriate, for the Treasury to reiterate the guarantee on securitized instruments issued by Fannie and Freddie. It's an entirely different matter for it to now extend its risk-removing support to subordinated debt which carried a higher initial yield, thanks to its riskier status, relative to senior debt.

As the Journal editorial pointed out, in support of the view that investors generally believed the subordinated GSE debt to be unguaranteed,

"And, indeed, as investor anxiety grew this summer over the fate of the two companies, the spread between the price of Fannie subordinated debt and U.S. Treasurys widened enormously. Investors feared a sub-debt wipeout."

Meaning that investors did not consider the subordinated debt to be guaranteed.

Paulson's actions in support of the subordinated debt holders has caused some traders to waggishly joke that he's the Secretary for the Chinese Treasury, rather than, or in addition to, that of the United States.

Jokes aside, this was one aspect of the Fannie and Freddie takeover that was unnecessary, expensive and sent a shockingly bad signal to investors.

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