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Fannie-Freddie Bailout From the Top Down

The Treasury's solution is unlikely to be viewed as a cure-all for the housing problem.

I believe that most investors will ultimately recognize that the announced solution to Fannie Mae'sundefined and Freddie Mac'sundefined problems was already built into market prices, as evidenced by the recent performance of both the common and preferred shares of the two companies as well as the recent compression of credit spreads for agency debt. In recent days, it was also obvious from the way investors were grumbling about being held in limbo on the GSE issue that something had to happen soon. The most prescient call on this front was the now-famous virtual pounding on the table on television last week by Bill Gross at Pimco, whose clear and concise voice was a clarion call and warning to Hank Paulson to put the finishing touches on the capital-fortifying plan and announce the Treasury's takeover of the GSEs.

The Treasury's solution is unlikely to be viewed as a cure-all for the housing problem -- the elimination of the excess supply of unsold homes is the cure -- but it is one of many things that had to happen in order to fix the housing problem. This means that there will be continued low valuation of mortgage collateral, bank failures and general angst in the financial sector, at least until home prices bottom, which I again emphasize depends upon the inventory picture. The Fannie/Freddie solution merely enables the liquidation process to continue; it will not hasten the process.

Consumer sentiment probably won't be buoyed much by the bailout because the bailout in itself is unsettling and complicated, which will overwhelm any sense that the bailout will keep the drops dripping from the spigot for the financing of mortgages. In the end, people care most about the value of their own homes, anyway.

I think it good that the GSEs are being allowed to expand their portfolios (to $1.7 trillion from $1.5 trillion) before shrinking them (to $500 billion), which will keep money flowing into the housing market and help bring inventories and hence prices into a more stable condition. There is risk, however, in the timeline, as the new rules call for the GSEs to begin shrinking their portfolios by 10% per year beginning in 2010, which will likely be well before the inventory situation has been materially improved. Fingers will be crossed in hopes for a meaningful drop in home inventories by the end of 2009, or at least an extension of time before the GSEs are shrunk. Thank goodness progress has begun on this front, at least in the new home category, and prices are now more consistent with incomes and rents.

Treasury yields were set to rise before the GSE announcement because yields fell too close to the funds rate and the


is not likely to cut interest rates. For example, the two-year note was trading under 2.20%, and it is rare that Treasury yields fall below the funds rate unless a rate cut is less than six months away. It is not likely that we'll see a major increase in Treasury yields, however, as the housing problem has not gone away and there remains the potential for adverse feedback loops where problems in the economy feed back to the financial sector and vice versa. Credit spreads are unlikely to narrow substantially as a result of the Fannie/Freddie bailout, although they could narrow in the very short-run. The outlook on company bonds is far more dependent upon the economic outlook and the outlook for corporate profits and corporate cash flows.

After an initial hit, the bailout of the GSEs will help keep the dollar's rally intact, which is extremely important to the economic outlook given the benefit that the economy will reap from the decline in commodity prices. Moreover, I believe that the dollar rally is creating vast pent-up investment dollars for riskier assets, as vast sums of cross-border capital flows have been directed to the U.S. of late. I believe there is the potential for a very large rally in share prices as a result of the capital flows. Seen another way, any decline that occurs in share prices will be reduced by the infusion of capital from abroad, as the world is now in the midst of a massive unwinding of commodity-linked investments, which for many reasons benefit the dollar more than most other major currencies.

P.S. I publish my third



Investing From the Top Down: A Macro Approach to the Capital Markets

, this week.

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At the time of publication, Crescenzi had no positions in the stocks mentioned.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic,

The Money Market

, first published in 1978 by Marcia Stigum, and

The Strategic Bond Investor

. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;

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