Taking Stock of Bonds

November 19, 2007

Wake Up Call

It's been generally accepted that US housing agencies Freddie Mac and Fannie Mae are immune to problems in the subprime mortgage arena, but the share prices of the government sponsored enterprises suggest some investors may have changed their thinking.

On Monday, Freddie Mac shares were off $3.93 at $36.79. A year ago, Freddie shares changed hands at just under $70.00 each. Fannie Mae, meanwhile, saw its shares fall $2.74 at midday Monday from $37.92. A year ago Fannie Mae paper was being sold at $57.93.

So, what gives? Investors may be viewing the GSEs as essentially bond insurers of a different stripe.

Both housing agencies support the purchase of homes through several roles. They buy mortgages and mortgage backed securities and, most importantly, they sell guarantees that a home buyer will make his or her monthly mortgage payment on time each month. The two housing finance giants sell the guarantees to lenders who can then use them to resell their mortgages as Fannie or Freddie mortgage bonds. That particular role in the housing finance machine has them looking more and more like bond insurers.

The bond insurer sells an insurance policy for securities, ensuring the principle and interest will make its way to bond holders on time. The housing agencies merely provide the insurance of timely payment earlier in the bond creation, or securitization, process.

To get an idea how investors feel about bond insurers in this era of credit worry, one ought to look at Ambac and MBIA stock prices.

MBIA – a bond insurer – has seen its share price droop to $33.21 from $73.31. Ambac – another financial guarantor is off from a 52-week high of $96 a share. At midday Monday Ambac shares were at just over $24.10.

While housing agency mortgage debt is considered better quality because it has presumably better underwriting standards, investors may be coming to the conclusion that problems once relegated to a market for less creditworthy borrowers leapfrogged to the Alt-A market and now may impact certain agency mortgage securities, particularly adjustable rate mortgages.

Could it be that investors are finally realizing that in the insurance business, when the storm shows up somebody will have to pay for the damage left behind? In this case the storm, an August tempest, is lingering well into the fall.