Bond Expert: Friday Outlook

Includes: FMCC, FNMA
by: John Jansen

Prices of Treasury coupon securities have registered modest losses in overseas trading. The yield on the benchmark 2 year note has climbed 4 basis points to 2.44 percent. The yield on the benchmark 5 year notes has climbed the same amount to 3.11 percent. The yield on the 10 year note has risen by 2 basis points to 3.82 percent and the yield on the Long Bond has climbed 2 basis points to 4.43 percent.The 2year/10 year spread has flattened by 2 basis points and trades around 138 basis points.

The price action has me in a bit of a quandary as stocks are down sharply and the press is reporting serious discussions of a government takeover of FNMA and Freddie Mac. Bloomberg has a story which contains the seeds of the problem for the treasury market.

Bloomberg reports that yields have risen because a government takeover would guarantee the debt of the agencies and would effectively reduce the safe haven bid for Treasury paper.

I think that opens an interesting conversation . There are a myriad of ways for the government to assuage the fears of the markets regarding the debt of the agencies. I am not sure that a complete takeover and outright gurantee is the most effective proposal. I believe that the NY Times article  stated that such a takeover would double the size of the national debt. (From the New York Times, the paper of record, this morning: a report of serious conversations amongst policy makers regarding plans to take over Fannie Mae and/or Freddie Mac.)

In that event, I think that the ratings agencies or the markets would downgrade (formally or informally) the debt of the US government. And I think that the reserve currency status might ultimately be challenged as investors around the globe view our profligate ways with a jaundiced eye. Such a move might be the catalyst for portfolio moves in which long-time buyers of US debt decide that at the margins, their appetite is sated.

I think that the takeover, if it happens, should look to minimize the involvement of the government and should be done with an equity stake such as the government took with Chrysler back in the 1970s. That would throw the current shareholders under the metaphorical bus and insure that any upside accrues to the taxpayers.

It might be possible for the US government to buy an equity stake via some preferred shares or maybe the existing entities could issue some very cheap warrants to the US government. I believe the most effective plan will seek to minimize and diminish the role of the taxpayer as guarantor.

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