15 Staff Report - Federal Home Loan Coupon Notes Investment StrategiestiN K 0 MEETING DATE: 8/18/2008
ITEM NO: 15
SOS cap°5 COUNCIL/AGENCY AGENDA REPORT
DATE: AUGUST 14, 2008
TO: MAYOR AND TOWN COUNCIL/
CHAIR AND MEMBERS OF THE REDEVELOPMENT AGENCY
FROM: GREG LARSON, TOWN MANAGER/EXECUTIVE DIRECTOR
A9--X--
SUBJECT: ACCEPT STATUS REPORT AND CONSIDER DISPOSITION OF FANNIE
MAE AND FREDDIE MAC FEDERAL HOME LOAN COUPON NOTES
INVESTMENT STRATEGIES
RECOMMENDATION:
Accept Status report and consider disposition on Fannie Mae/Freddie Mac and Federal Home
Loan Bank coupon notes investment strategies. Council should consider one of the following
strategies:
1. Continue with Treasurer's and staff recommendation to maintain its current "hold
to maturity" strategy in accordance with the Town's investment policy; or
2. Continue hold to maturity strategy for Federal Home Loan Bank notes and sell
selected holdings of Fannie Mae/Freddie Mac yielding less than 4.25%, totaling
approximately $2.3 million and explore opportunities to reinvest in other
government sponsored enterprises that yield approximately 3.85%; or
3. Continue hold to maturity strategy for Federal Home Loan Bank notes and sell all
holdings of Fannie Mae/Freddie Mae totaling approximately $8.2 million and
invest proceeds in alternative instruments such as U.S. Treasury notes or other
government sponsored enterprises.
PT TRPOgF.-
The purpose of this report is to inform the Council about the status of the Town's Fannie Mae/
Freddie Mac investments in light of recent econoinic and market developments. The report
provides an overview of recommended investment strategies and associated fiscal implications,
PREPARED BY
S4qA ON Y
Finance & r t rative
Services Services Director
NARNANCE1StephenTinance CommitteeTannic Mae Freddie Mae status report 8_15.doc
Reviewed by: Assistant Town Manager/Deputy Director Town Attorney/General
Counsel Clerk Administrator/Secretary Finance
Community Development
PAGE 2
MAYOR AND TOWN COUNCIL/CHAIR AND MEMBERS OF THE REDEVELOPMENT
AGENCY
SUBJECT: ACCEPT STATUS REPORT AND CONSIDER DISPOSITION OF FANNIE
MAR AND FREDDIE MAC FEDERAL HOME LOAN COUPON NOTES
INVESTMENT STRATEGIES
AUGUST 14, 2008
as discussed with the Council Finance Committee. Staff is seeking Council direction regarding
the preferred investment strategy and implementation steps.
DISCUSSION:
CURRENT STATUS OF FANNIE MAE/ FREDDIE MAC AND FEDERAL HOME
LOAN BANK INVESTMENTS
The following page provides a summary of the Town's current holdings in Fannie May and
Freddie Mac "coupon notes," as of July 31, 2008. These investments are corporate bonds that
pay a fixed, semi-annual interest rate. Also included is a summary of Town holdings in Federal
Home Loan Bank notes, a regional bank cooperative which are not actively being discussed in
the market or financial press at this time.
Institution
Amortized Cost
Yield to Maturity
Maturity Date
Days to Maturity
Fair Market Value
FannieMae
$ 199,216
3.866%
09115108
77
$ 200,250
FannieMae
248,158
3.974%
09115/08
77
250,313
FannieMae
199,552
1936%
11117108
140
200,626
FreddieMac
296,403
4.313%
01/12/09
196
301,593
FannieMae
242,400
3.930%
03116109
259
250,548
FreddieMac
300,198
4.359%
07130/09
395
304,218
FreddieMac
298,332
4.527%
07130/09
395
304,218
FreddieMac
149,687
4.180%
09101109
428
151,857
FreddieMac
298,683
4.237%
09101/09
428
303,714
FreddieMac
299,331
4.431%
01125/10
574
305,862
FreddieMac
1,008,560
4.007%
12/24110
876
1,005,990
FannieMae
1,516,485
4.874%
04115111
988
1,563,285
FreddieMac
1,522,350
5.375%
07120/11
1115
1,531,500
FannieMae
1,260,300
4.562%
01/02/13
1616
1,260,550
Total FNMA/Freddie Mac $ 7,839,654 $ 7,934,523
FHLB
$ 1,498,035
5.298%
03/13/09
225 $
1,498,035
FHLB
1,493,400
5.226%
06/12/09
316
1,493,400
FHLB
1,507,665
4.957%
06111/10
680
1,507,665
FHLB
1,487,205
4.960%
08/10/10
740
1,487,205
FHLB
1,509,255
4.743%
03/09/12
1317
1,509,255
FHLB
2,038,360
4.170%
08/15112
1476
2,038,360
Total FHLB $ 9,533,920 $ 9,533,920
The Town currently holds approximately $7.8 million (10% of the Town's investment portfolio
of approximately $76.7 million) in Fannie Mae and Freddie Mac investments. As of July 31,
2008, the sale of these investments at fair market value would yield a gain of $96,000.
PAGE 3
MAYOR AND TOWN COUNCIL/CHAIR AND MEMBERS OF THE REDEVELOPMENT
AGENCY
SUBJECT: ACCEPT STATUS REPORT AND CONSIDER DISPOSITION OF FANNIE
MAE AND FREDDIE MAC FEDERAL HOME LOAN COUPON NOTES
INVESTMENT STRATEGIES
AUGUST 14, 2008
According to MBIA Asset Management, investments that have shorter maturity dates and lower
yields are currently expected to either result in a small profit, breakeven, or potentially incur a
small loss of principal if sold in the near term due to the fluid nature of the market coupled with a
general rise in interest rates over the past two weeks.
OUTLOOK ON FANNIE MAY AND FREDDIE MAC INVESTMENTS
The following section provides an overview of the benefits and challenges of Fannie Mae and
Freddie Mac Investments, including the Federal Home Loan Bank.
Fannie Mae
Fannie Mae is a government sponsored enterprise {GSE} that facilitates the availability of capital
used in providing financing for mortgages nationwide. Fannie Mae has dramatically increased
the cost to guarantee mortgage-backed securities by roughly 50% on average. Mortgage profits
have widened on new loans and underwriting standards have tightened. As new loans replace
the old, it is anticipated that additional profits and returns on capital will grow. Analysts for
Morningstar reported that "Fannie Mae's implicit government guarantee is becoming more
concrete day by day." Bloomberg Investor's Report indicated that investors continue to buy
these notes and recently announced that Fannie Mae sold $3.5 billion in new Three Year Notes,
yielding 4.22 per cent.
However, experts stated that the velocity of housing turnover and refinancing may continue to
decline, leaving troubled loans on Fannie Mae's books and reducing opportunities to increase its
revenue stream. Further disruption could result in government intervention to prevent massive
market impact. According to Bloomberg Investors, since December 2007, Fannie Mae has
raised $14.4 billion in new capital to offset credit losses as delinquencies rise and the rate of
recovery on foreclosures slides. Freddie Mac has raised $6 billion since late last year, and is
struggling to raise another $5.5 billion in stockholder equity investments according to investment
sources.
Freddie Mae
Freddie Mac is considered an integral part of the mortgage market, committed to providing
liquidity to the mortgage market, and is planning to purchase $20 billion in new fixed and
adjustable rate mortgages. Experts use the term "the only game in town" because of their unique
position as a GSE. The risk of fluctuating interest rates is offset by Freddie Mac's strategy in
which it pairs its loan assets with its borrowings from the financial market that possess similar
interest rates and maturities.
Despite its unique position as a GSE, Freddie Mac has been the subject of much speculation,
given its recent loss which was three times higher than analyst's expectations. Experts believe
that Freddie Mac's significant use of derivative instruments complicates the financial analysis of
the firm and increases the level of uncertainty in the performance of its business.
PAGE 4
MAYOR AND TOWN COUNCIL/CHAIR AND MEMBERS OF THE REDEVELOPMENT
AGENCY
SUBJECT: ACCEPT STATUS REPORT AND CONSIDER DISPOSITION OF FANNIE
MAE AND FREDDIE MAC FEDERAL HOME LOAN COUPON NOTES
INVESTMENT STRATEGIES
AUGUST 14, 2008
Federal Home Loan Bank
The Federal Home Loan Bank's (FHLB) function is to loan funds to its member banks. These
funds are then available to be loaned out from its member banks to their communities in the form
of mortgages and small business loans. These loans are considered well "over-collateralized"
and have never experienced a single loss on its advances to its member banks since their
inception. Additionally, Standard and Poors recently issued a rating digest indicating an AAA
rating due to FHLB's role in the U.S. Mortgage market, excellent asset quality, conservative
risk-adjusted capitalization, and its low funding costs. Although the relationship is indirect, there
will always be some degree of exposure given FHLB's association with home loan financing.
However, should the FHLB system experience financial distress, Standard and Poors reports that
"the federal government would have a strong incentive to provide financial support to ensure the
stability of the housing and capital markets."
Other Considerations
The recent adoption of the Federal Housing and Economic Recovery Act is evidence of an
implicit government guarantee to prevent a system-wide collapse and housing market chaos.
Sharp losses at Fannie Mae and Freddy Mac over the past week and continued concerns about
the U.S. credit market have increased the chance that government funds would be needed.
According to the Wall Street Journal Forecasting Survey, there is a 59% probability that the
Treasury Department will have to step in to bail out Fannie Mae or Freddie Mae. However, a
bailout which would likely involve a government equity stake in Fannie Mae or Freddie Mac
would not necessarily undermine the value of the Town's investment.
RECOMMENDED STRATEGIES
Town Treasurer and MBIA Asset Management
The elected Town Treasurer and MBIA Asset Management concur that the current "buy and hold
to maturity philosophy" as stated in the Town Investment Policy is the best course of action for
the Fannie Mae and Freddie Mac notes and recommend no change to the holding and investment
strategy for Federal Home Loan Bank notes. The recommended strategy is based on the
following assumptions:
■ New federal legislation allows the U.S. Treasury to buy unlimited shares of stock and
debt of Fannie Mae (FNMA) and Freddie Mac (FHLMC) to bolster capital.
■ The Treasury Department significantly increased the lines of credit to FNMA and
FHLMC from $2.5 billion to an estimated $300 billion.
■ FNMA and FHLMC have access to the Federal Reserve discount window to
meet liquidity needs, as needed.
■ FNMA & FHLMC own or guarantee over 80% of all residential mortgages in 2008. As a
result, economists strongly speculate that that government may be counting on FHLMC
and FNMA to pull the housing market out of the recession.
PAGE 5
MAYOR AND TOWN COUNCIL/CHAIR AND MEMBERS OF THE REDEVELOPMENT
AGENCY
SUBJECT: ACCEPT STATUS REPORT AND CONSIDER DISPOSITION OF FANNIE
MAE AND FREDDIE MAC FEDERAL HOME LOAN COUPON NOTES
INVESTMENT STRATEGIES
AUGUST 14, 2008
FNMA and FHLMC benefit from the implied guarantee of the government acting as a
Government Sponsored Enterprise (GSE). Recent activity indicates that the guarantee is
real.
The Town only invests in the AAA rated senior unsubordinated debt of FNMA and
FHLMC, these ratings remain unchanged. The Town does not own equity or
subordinated debt, which could be negatively impacted by the downturn in the housing
market.
Town Council Finance Committee
The Council Finance Committee recommends a modified "buy and hold to maturity" approach.
This approach would require Council to request that the Elected Treasurer sell approximately
$2.3 million of Fannie Mae/Freddie Mac investments that return an effective yield of less than
4.25% to the Town. The remaining $6 million in Fannie Mae and Freddie Mac notes would be
held to maturity. This action would decrease the Town's exposure in Fannie Mae/Freddie Mac
investments, but retain higher yielding notes, earning interest for Town operations.
MBIA Asset Management believes the sale of these shorter term maturities would result in a
break even, small gain, or small loss on principal. The Treasurer indicated that the net proceeds
could be reinvested in other GSEs, such as the Federal Farm Credit Bank for an annual return of
approximately 3.9%. The Council Finance Committee recommends no change to the holding and
investment strategy for the Federal Home Loan Bank notes.
Town Staff
Staff recognizes the current uncertainty in the housing market and the concerns of the Council
Finance Committee. While there is some level of risk in the "hold to maturity" approach, staff
supports the recommendation of the Treasurer and MBIA Asset Management Advisory Services.
However, staff agrees that the risk of loss could be reduced or mitigated by the proposed sale of
some of the maturities and reinvesting in other notes, as recommended by the Finance
Committee. Staff also recommends no change to the holding and investment strategy for the
Federal Home Loan Bank notes.
CONCLUSION
As part of its investment strategy, the Town has prudently used diversification to achieve returns
that contribute to the financial stability of the Town. This result has been accomplished by using
a variety of financial instruments, including U.S Treasury notes, investments in the Local
Agency Investment Fund, government-sponsored enterprises like Fannie Mae and Freddie Mac
notes, and highly rated corporate notes, all of which have varying degrees of risk as allowed by
state law.
PAGE 6
MAYOR AND TOWN COUNCIL/CHAIR AND MEMBERS OF THE REDEVELOPMENT
AGENCY
SUBJECT: ACCEPT STATUS REPORT AND CONSIDER DISPOSITION OF FANNIE
MAE AND FREDDIE MAC FEDERAL HOME LOAN COUPON NOTES
INVESTMENT STRATEGIES
AUGUST 14, 2008
It is staff's position that the Town's portfolio is properly balanced in part by the Fannie
Mae/Freddie Mac notes, which consistently provide the Town competitive returns. While
holding these investments does have some risk of uncertainty, the "buy and hold to maturity"
philosophy continues to be a sound approach in portfolio management. However, given the
current economic uncertainty, Council may wish to explore other investment alternatives as
suggested by the Council Finance Committee.
FISCAL IMPACT:
The estimated fiscal consequences of each alternative strategy are presented in the following
table for Town Council's consideration.
Interest Principal
Treasurer and MBIA-"Buy
and Hold" Approach
Comments
None, tuft prmetpat
paid upon maturity of Assumes no loss of principal due to
$ 878,000 investment, failure of FNMA or Freddie Mac
Potential small gain, Shorter term lower yielding
break-even scenario, investments in FNMA and Freddie
ante Committee "Modified
V and Hold" approach
Sell entire position in FNMA
and Freddie Mac notes and
reinvest in average 3.4%
investments.
or potential small loss Mae are subject to risk of loss of
$ 872,000 of invested principal. principal as interest rates rise.
Likely an overall "one•
time" gain of
approximately $40-
70K depending upon
prevailing interest
$ 655,000 rates
Not a current recommendation of
Town Treasurer, Finance Commit
or staff.