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Fannie and Freddie: We All Support You!

by: Dear John Thain September 07, 2008 | about stocks: FNM / FRE    

Dear John Thain

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Well, it seems like this slow motion trainwreck is finally going to compel some action.  Jeeze. The more one reads the more ridiculous this whole thing is…

1. Fannie and Freddie are not created equal (no one “in  the know” ever thought they were…). Apparently Freddie is under-capitalized and Fannie is still smelling the flowers on their way to being under-capitalized (from the NYT article):

Then, last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined…

While Freddie Mac’s accounting woes make it easier for regulators to force the company into conservatorship, there was more resistance from Fannie Mae, according to people familiar with the discussions. Once the government took action against Freddie Mac, however, confidence in Fannie Mae would certainly waver. Given Fannie Mae’s declining financial condition, the company has few options but to concede to the government’s demands.

Fannie Mae is resisting? 

2. Taxpayers are about to own a whole lot of crap. Of course I already noted the large amount of non-prime mortgages sitting on the G.S.E.’s books (and the poor credit metrics)… But, apparently, the marking to market of these securities isn’t hurting their capital position. Oh, holdon, stop celebrating–it’s because they don’t mark the portfolio. Here ya go (from the NYT article):

Freddie Mac’s portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices.

Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value. But other financial institutions have written down similar securities, to comply with “mark-to-market” accounting rules. Freddie Mac holds roughly twice as many of those securities as Fannie Mae.

(emphasis mine).

3. It also seems that complaints from foreigners are causing the Treasury to take these steps:

The proposal to place both companies, which own or back $5.3 trillion in mortgages, into a government-run conservatorship also grew out of deep concern among foreign investors that the companies’ debt might not be repaid. Falling home prices, which are expected to lead to more defaults among the mortgages held or guaranteed by Fannie and Freddie, contributed to the urgency, regulators said.

Investors who own the companies’ common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

(emphasis mine).

Now, let me make a point here: The decision to back only debt and not preferreds and common stock is completely arbitrary.

Let’s fly off on a tangent and ask ourselves what would happen if government backing of the debt occurred as a singular event–nothing else happened. Well, then, the guarantee that everyone thought was in place would be in place. The market, credit conditions, and the housing market would most likely wipe out equity anyway. So, then, why does the government need to do this explicitly? Just take over day-to-day operations… They are regulated entities, it’s not a stretch to strike a deal where the regulator ousts management and takes over!

Making this guarantee explicit, by the way, will also make holders a hefty profit as spreads will undoubtedly rally for agency debt–a nice gift to foreign holders of this debt at the expense of the shareholders current financial holdings, it seems.

4. I would look for a very, very serious revisiting of a lot of transactions. This would clearly be very controversial, but if I were advising regulators and the government, I would start taking a strict view of the G.S.E.’s charters, and unwinding whatever I could. No way the G.S.E.’s should have ever owned subprime loans or bonds. I also have a feeling that there are clauses that allow for some kind of “regulatory put” on many transactions if  deemed outside the G.S.E.’s authority or charter. Will the government go through these? Maybe. Truth be told, they need to de-lever these behemoths and raise capital cushions somehow. 

5. Look for a big Merrill-like trade. Who could be the buyer? I wonder…

Did you catch Bill Gross on CNBC just now? They asked if he had been approached by the Treasury about any government-led solution, presumably asking if PIMCO would participate. Gross said he couldn’t comment, which means the answer is yes.

Okay… now about an hour until the details are confirmed. We’ll see what happens.

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This article has 19 comments:

  •  
    Sep 07 10:32 AM
    The reason the GSE's owned any subprime paper was because the government was leaning on them to do more to support "affordable housing", and they figured that buying some of the more insulated traunches of offerings backed by subprime mortgages was the cheapest and safest way to do that. So, in summary, they own subprime because the government told them to buy it.
    Reply
  •  
    Sep 07 11:18 AM
    I agree that it was the government pressing Fannie & Freddie....incidentall... the government in power at the time was, and is the Republicans. Until, about 4 years ago, FNM &FRE were considered the best run companies. Then the government.."Bush... (and Republicans in Congress) started questioning Fannie about all sorts of esoteric"accounti... procedures and had questions about management. Too much pressure from politicians...I remember talking to my friends and wondering out loud about why the Republicans were after 2 well run companies, FNM & FRE. Now we know, they were out to force the fake housing issue to move the economy, and in the process successfully destroyed 2 previously well run companies, and for a short time boost to the economy. The genie is out of the bottle, and FNM & FRE cannot be put back into the successful companies they used to be...in fact, we are now looking at bangruptcy for both!! Our political powers at work!!
    Reply
  •  
    Sep 07 11:21 AM
    The focus on credit quality (subprime, etc.) is misplaced and self-deceptive. Had real estate prices continued to rise, the default rate would be irrelevant. The real problem wasn't that people with bad credit were getting loans, it's that everyone who wanted to own a house was able to do so. That's the definition of a crowded trade. Add in excessive leverage and you have a classic disaster waiting to happen. It would not have made any difference if all the borrowers had spotless credit and documented income; many people simply are not going to make payments on a loan backed by no equity and an asset that is declining in price, and when the collateral is declining in value and you are geared up 50x on the paper, even ordinary default rates are enough to kill you.

    This is why the GSEs should never have existed and why they need to die at the first opportunity: if home ownership really is for everyone, what happens next? Suppose the government were instead to believe that ownership of AAPL were for everyone, and set up an infinitely-capitalised firm to buy up and/or borrow shares and sell them to anyone who wants them at a fixed price, on credit. Econ 101 quiz question: what happens to the market price once everyone who wants the shares has bought them from this entity? If you said "it collapses", move to the head of the class. There are no buyers left, and all it takes is one leveraged long getting a margin call to set off a chain reaction. As long as the government continues to talk about the "ownership society" and make housing artificially available, the trade will continue to be crowded and periodic crises will occur. Restructuring the GSEs or changing regulations is just rearranging the deck chairs.
    Reply
  •  
    Sep 07 11:47 AM
    Actually management executed their strategy flawlesslessly. Fleece the shareholders by taking out big paychecks. It was the gross negligence of the regulatory apparatus and the lax management of the Fed that made htis whole debacle possible.
    Reply
  •  
    Sep 07 11:52 AM
    WHAT HAPPENED TO "SOFT LANDING"?
    Reply
  •  
    Sep 07 11:59 AM
    I am a holder of Fannie Mae common stock. Most of what has transpired in the financial markets over the past 12 months is truly beyond my grasp. What I truly do not understand--and wish someone could explain to me--is the consensus I've heard saying that the shareholders of Fannie and Freddie need to be punished. I'm a little guy who bought shares in the company many years ago because everybody told me how safe an investment it was. I am not a trader, nor a speculator and I'm sure others put a lot of their nest-egg into Fannie for the same reason. Why do I and many others such as myself need to be "punished?"
    Reply
  •  
    Sep 07 12:28 PM
    MediaGuy, this resembles a Chapter 11 in its effect for the holders of common stock. Existing equity capital is cancelled and charged off. Why did you ride the price to zero when everyone else was running for the exits? Was it because you misunderstood that the "implicit government guarantee" did NOT pertain to someone's ownership interest in the enterprise?
    Reply
  •  
    Sep 07 12:32 PM
    MediaGuy,

    Here's what I think.

    You and investors like you are the poster children for what is wrong with financial markets: the markets are crooked, rigged, shams that do not have any relevance for long term investors. You bought shares in a lie and didn't know it. The lies are spread thick and without consequence. The lies include loan origination (overstatement of appraisals of homes and creditworthiness of borrowers), the wink-and-nod of "government sponsorship", the securitization process and its attendant overrating of securities by ratings agencies, the Central banks' willingness to keep pumping in cheap money to keep the economy on an upward track, the regulators' willingness to knowingly look the other way, the revolving door of government service to Investment Bank and then back to government "service".

    The whole thing is a sham. You were robbed, plain and simple, by a crooked system designed to get the limited-knowledge little guy to buy something that the big guys knew would be worthless someday. They knew when to sell; you are too busy trying to earn a living and keep your family together to pay constant attention to the "markets", so you didn't know when to sell. Classic pump-and-dump, but all very legal.

    The only way to protect yourself from this is to not play. Once J6P figures this out and stops sending new 401(k) money into these markets, the game is over.
    Reply
  •  
    Sep 07 12:39 PM
    MediaGuy said
    ...Why do I and many others such as myself need to be "punished?"....

    The problem you have is in the statement
    ...I'm a little guy who bought shares in the company many years ago because everybody told me how safe an investment it was....
    This contradicts the basic tennet of investment in a capitalist society. You gain excess rent (profit) because you take risk. If there is no risk, no profit. You are paying for your ignorance, not being punished. That is almost always expensive. Common stockholders are *always* the people who lose first in a financial disaster at a firm.

    And you haven't been wiped out yet, and in fact there is a chance you will do well. This is a bankruptcy by another name, and it is possible the GSEs will come out of it with common stock still having value. And if this intervention turns the market around, you could participate in a nice rally and even make money.
    Reply
  •  
    Sep 07 12:39 PM
    You need to be punished because you bought stock in a company that made risky bets and lost. That's how the stock market works. There isn't supposed to be a way that shareholders in stocks can get their losses paid back from the US Treasury by taxpayers who are taxed by force.

    The US government from the time of the Clinton administration has confirmed that it doesn't have enough money to feed poor children, house the homeless, provide emergency medical services to the indigent. The reasons for this were ideological. Capitalism is good for people. If you feed poor children, they won't have an incentive to work hard and make their own money. We are an ownership society and if you give the poor a hand out, you create a "culture of poverty."

    So, you can imagine that these same people who are handing now enough money to JP Morgan Chase, to investment banks, stock brokerages, commercial banks, Fannie and Freddie and so many other investors that the same amount of money would be more than enough to take all of the poor people in the United States and not just give them something to eat, but enough to buy them all homes and cars and LCD TVs and put them in the middle class. We're talking about trillions before this is over. So the idea of taking that money and giving it to you because you are a "little guy" who is losing money on a stock you bought is dangerous. It's the sort of thing that sparks revolutions. And I would remind you, Sir, that if revolutions were foreseeable, those in power would generally have not made the last several major decision that they made leading up to the revolutions. The public is probably stupider now than at any time since the middle ages, so this sort of theft is viewed as safe because the incredible moral turpitude, the theft, the outrage -- the public can't experience that if they are too stupid to understand that it is occurring.

    In short, if single unwed mothers living in poverty can't have a hand out, then you two shouldn't ought to get one. Under social and moral principles embedded in western and eastern civilizations for thousands of years, it is unpalatable to take from the poor and give to the rich. And even if you are a "little guy" I'm going to imagine you are typing out your post from a soup kitchen or shelter, right?
    Reply
  •  
    Sep 07 01:08 PM
    MediaGuy, it's not punishment in the sense that you did something wrong. It's that investors, traders, and speculators alike need to be reminded that they are taking risks and that those risks can turn out badly. If equity holders are made whole by government bailouts, the reasoning goes, they will come to rely on that happening in the future and will take increasingly bad risks in the quest for greater returns. By crushing out common and in some cases preferred shareholders in a bailout or chapter 11 restructuring, the regulators/courts ensure that bad risks are not rewarded.

    Now, I would also make the case that debt holders should bear the cost, not the Treasury. In a typical chapter 11 restructuring, equity is wiped out or replaced by warrants, subordinated debt is given a big haircut and converted into equity or cashed out, and senior debt is either converted into equity or subordinated to bankruptcy financing. Obviously, there are many variations depending on the specifics of the company and the creditors' desire, but the bottom line is that creditors take over the company and some or all of their debt is converted into equity. The same thing should have been done with FNM and FRE, forcing creditors to assume the usual risks associated with lending. I suspect this was not done because two of the largest creditors are China and Russia. Both have lots of guns and plenty of people willing to shoot them at people like Mr. Paulson, and all China has to do to have its way with the US is threaten to start selling Treasuries. So what is not being said here is that this was basically an exercise in loan-sharking and the US got its kneecaps broken. Such things happen to those who borrow recklessly.

    Now to your situation. You bought something you didn't understand. Why? If you didn't understand it, you should have done more research and/or asked questions of your financial advisor (the person you pay and trust to help you make sound financial decisions) until you did understand it, or you should not have purchased it. Whoever the "everybody" was that told you that a common stock was a "safe investment" was lying to you; if he or she had a fiduciary responsibility to you, you may have a legal case to consider. In any case, it undoubtedly sounds callous, but you are simply going to have to learn your lesson, take your lumps, and move on. If it makes you feel any better, I had no position in these companies and STILL got taken to the cleaners - if anyone deserves sympathy here, it's the taxpaying public who did not buy these companies, did not leverage themselves to buy houses, and did not overpay for junk.

    In the future, take the time to understand what you are buying, or stick to green paper money, FDIC-insured savings accounts, and 3-month T-bills (I'll spare you a detailed explanation of why these too are risky, because they are about as close as you can get to risk-free given that you choose to keep score in dollars). And above all remember that there is no such thing as a perfectly safe investment. SWRichmond says you were robbed; I disagree though I could be brought around to that point of view if it turns out your advisors did not properly disclose the risks. But we both agree that you should not be in participating in the capital markets, and unless you change your approach radically you will continue to lose money as long as you are doing so.
    Reply
  •  
    Sep 07 01:34 PM
    Those of you who are lecturing mediaguy about the free market system and how it works:

    If we had a virtuous free market system, you would be right.
    Reply
  •  
    Sep 07 02:08 PM
    to the legions of quasi-free market capitalists who think that the government should bail out stockholders in addition to bondholders:

    government backing of GSE equity was never promised or implied.
    long time investors have my sympathy but not my understanding. bottom fishers and speculators deserve neither.
    Reply
  •  
    Sep 07 03:10 PM
    What is a good short term bet on the Fannie Freddie news? UYG of SKF?
    Reply
  •  
    Sep 07 03:22 PM
    The shareholders of the GSEs aren't being wiped out because of business risks gone bad, they're being wiped out because of political risk gone bad. We weren't supposed to have to worry about political risk when we invested in the United States. The Treasury has just shown us that we now do. I would expect that reality to have major long-term negative implications for investment in the United States going forward.
    Reply
  •  
    Sep 07 03:24 PM
    Mediaguy is not alone. Lots of very smart people (i.e. Bill Miller, Rich Pzena) , including some not so smart people like me, took a chance and lost. However this is a minor skirmish in the never ending war to seeking alpha.

    There should be nice short term rally in financial s in the coming weeks.
    Reply
  •  
    Sep 07 06:50 PM
    >>> By crushing out common and in some cases preferred shareholders in a bailout or chapter 11 restructuring, the regulators/courts ensure that bad risks are not rewarded. <<<

    I think our capital structure priorities are exactly backwards. The stockholders are the owners of a company, while bond holders are simply people who lent money to the company for a fixed return. Since the company's performance is judged (and its value is set) in the marketplace by its share price, the shareholders automatically get punished if the company takes on too much risk or performs poorly. In a bankruptcy (or conservatorship, as in the case for FNM/FRE), shouldn't the bond holders be the first to lose their money after the unsecured creditors? They, too, should bear the risks of "investing" (by choosing to make loans to the company).

    Even if the assets of the company are explicitly tendered as collateral for the loan, shouldn't the original owners still own whatever is left? How do the owners get their company stolen out from under them and ownership handed over to someone else, while the company still exists and continues to operate? The only way shareholders should ever get "wiped out" is if and when the company is entirely liquidated and all assets are sold off (and even then, nothing is left after paying bond holders and other creditors).


    Why does everyone view stockholders as the bottom of the food chain, when they should be at the top of it? I simply don't get it.
    Reply
  •  
    Sep 08 07:43 AM
    Common shareholders are always last in line in a bankruptcy, or even in normal operations. You don't get to pay a big dividend to your shareholders right before defaulting on all of your debt, for example. So Paulson didn't change anything there. What he changed for shareholders was suspending the dividend and getting rid of all shareholder governance rights. So the shares are still out there, can still trade (until they become worthless and are delisted), but they carry none of the ordinary rights of shareholders. They're zombie shares.
    Reply
  •  
    Sep 09 05:44 PM
    I inherited shares of Fannie Mae stock from my mother, who was a retired employee of Fannie Mae when it was federal. It was around $85 per share, and over the last 6 years is now worthless, and we are the LOSERS here for the mishandling of this company. I'm absolutely appalled how much I've lost, and when stockholders should be applauded for hanging in there, we're now paying the cost for other's deceit. I certainly wish I had dumped it long ago, but believed this would eventually be a good stock ..and now this! WHERE are our rights to complain anyway???????????

    Designwom9@aol.com


    On Sep 07 11:59 AM MediaGuy wrote:

    > I am a holder of Fannie Mae common stock. Most of what has transpired
    > in the financial markets over the past 12 months is truly beyond
    > my grasp. What I truly do not understand--and wish someone could
    > explain to me--is the consensus I've heard saying that the shareholders
    > of Fannie and Freddie need to be punished. I'm a little guy who bought
    > shares in the company many years ago because everybody told me how
    > safe an investment it was. I am not a trader, nor a speculator and
    > I'm sure others put a lot of their nest-egg into Fannie for the same
    > reason. Why do I and many others such as myself need to be "punished?"
    Reply
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