Floating rate notes. Reading the Wall Street Journal Europe on 27 August 2008

I was flying from Munich airport on 27 August when I was struck by an article on the Wall Street Journal Europe bringing up the issue of the floating rate notes that are due basically now and during the forthcoming fifteen months. It reported about Alex Roever estimates, a J.P. Morgan Chase & Co. analyst who foresaw the credit crunch starting this month, September 2008, when banks were due to pay back $95 billion in floating rate notes. Fannie Mae and Freddie Mac have been both important issuers of these bonds. We know they were placed into conservatorship, a mild word for nationalisation, by the Federal Housing Finance Agency (FHFA) on 7 September.

Fannie Mae (FNMA) was born in 1938 as a government-founded agency as part of Roosevelt's New Deal to provide liquidity to the mortgage market. Until 1968 Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States. That year, and to help balance the federal budget, Fannie Mae was converted to a private corporation. This measure was accompanied with the creation of Freddie Mac and its chartering by the US Congress as a competitor in the secondary mortgage market, so that the actual monopoly would end. Their role was to provide liquidity for what are referred to as conforming mortgages, i.e. mortgages meeting certain minimum standards designed to reduce risk to the lender. Banks and other lenders would be able to sell conforming mortgages to both companies so they could replenish their funds and keep making mortgage loans without worrying about raising money to fund those loans. This way mortgage interest was kept at a much lower rate than it otherwise would have been.

What did Fannie and Fred do with these mortgages? They have been packaging them into the so-called mortgage backed securities and selling them on the secondary mortgage market with a guarantee that the interest and principal would be paid, whether or not the original borrower paid. At least as long as they had the financial solidity to cover these guarantees, of course. In addition to selling mortgage backed securities they also kept a number of mortgages for their own portfolio, which they were funding with a variety of debt securities. In particular they have been important issuers of floating rate notes, a type of bonds usually issued from one bank or financial institution to the other which have a variable coupon or interest given by the federal funds rate in the US or the LIBOR in Europe. All in all, Fannie and Fred were designed to make profit out of:

1. the difference between the interest rate to which they lend money to the original borrower and the interest rate that they write on the aforementioned mortgage backed securities -which is inferior because it is a guaranteed security-,
   
2. the difference between the interest rate to which they lend money to the original borrower and the interest rate that they have to pay to the holder of the debt security with which they fund their portfolio.

However, profit is not a compulsory outcome of the (quasi-) free market and Fannie and Fred have been suffering a negative net growth during the current economic cycle, driven to a large extent by the subprime mortgage crisis. As a consequence of their loss of solidity, liquidity in the mortgage market came to a halt. Also, debt securities issued by these two companies started being scarcely competitive, compared for instance to US government securities. To compensate for this, Fed interest rates are to be cut. Debt securities issued by Fannie and Fred can be found everywhere in the global markets, with a special mention to Chinese banks.

There have also been a few scandals in the management of these two companies that I will analyse in future posts.

What about Europe?
In Europe the main issuers of floating rate notes are banks. The stress they are going through at the moment has to be related to the due date of the floating rate notes mentioned by Mr Roever. The dubious ability of these banks to meet the deadline this month is probably an unconfessed reason because of which the European Central Bank and the national Central Banks are now going to the stake for them. I am afraid they fear the exposure of lack of liquidity of European banks which would spin out of control if savers panic.