The absolute best piece I've seen on Fannie Mae and Freddie Mac over the past few months is this recent item by Jonathan R. Laing in Barrons.
It's clear that something big is about to happen. What isn't clear is just how big it will be, how it might be mitigated, and who will be left standing when the music stops.
I've highlighted key portions of the article and will discuss each in turn.
First, not only will the Treasury recapitalize Fannie Mae and Freddie Mac, the point Laing is making is that the government will HAVE to do so. In other words, talk alone is no longer sufficient to shore up confidence. Paulson has played that game, but it's clearly not working to restore confidence. I'll discuss this at length in another post. What's important to know is the role confidence plays in a modern banking system.
Second, the loss of value is astounding. I can’t think of a public company that would still be standing having lost 90% of its value in a year.
Third, and perhaps most damning, the balance sheets have gone red on a fair-value basis. Freddie has a negative net worth of $5.6 billion. Fannie fares little better with only $12.5 billion covering $2.8 trillion in owned/guaranteed mortgage assets. The math is about as ugly as it gets.
Forth, fasten your seatbelt – even fair-value may be overstating the case. Laing notes that by some calculations, each company is about $50B to the bad.
Fifth, Alt-A speculative mortgages account for more than $500B of combined credit losses for Fannie and Freddie. Again, these are not sub-prime mortgages, the agencies bought or guaranteed these to boost their market share. Due diligence wasn’t diligent.
Sixth, Treasury Department attempts aside, it will be nearly impossible for Fannie and Freddie to get out of this situation by gaining new investors – the risks are simply too great to attract the kind of investment needed. Should the government decide bankruptcy is the path to take, foreign investors will change their path entirely.
Seventh, in Q2 Fannie raised $7.2B in equity – and lost all but $300M of it in the same quarter.
Eighth, even selling new stock would be hugely expensive. With preferreds going at 14%, the cost of capital is too high for either Freddie or Fannie.
Here’s the excerpt from Barrons:
IT MAY BE CURTAINS SOON FOR THE MANAGEMENTS and shareholders of beleaguered housing giants Fannie Mae and Freddie Mac . It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?"
Heaven knows, the two government-sponsored enterprises, or GSEs, both need resuscitation. Soaring mortgage delinquencies and foreclosures have led the companies to gush red ink for the past four quarters, and their managements concede the outlook is even grimmer well into next year. Shares of Fannie Mae (ticker: FNM) and Freddie Mac (FRE) have lost around 90% of their value in the past year, with Fannie now trading at $7.91, and Freddie at $5.88.
Similarly, the balance sheets of both companies have been destroyed. On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.
What's more, the fair-value figures reported by the companies may overstate the value of their assets significantly. By some calculations each company is around $50 billion in the hole. But more on that later.
Bringing Fannie and Freddie to heel will be difficult for the Bush administration, despite the GSEs' (Government-Sponsored Enterprises') parlous financial condition. Consider their history. In the early 1980s Fannie was effectively insolvent, but the government allowed it to continue operating. Eventually long-term interest rates dropped, bolstering the value of the company's mortgages and bringing it back from the brink. Earlier in the current decade Fannie and Freddie successfully fought a full-scale attempt by the White House and some brave Republican legislators to clamp down on their operations, after they were caught perpetrating accounting frauds.
Note, too, that Fannie and Freddie have nonpareil lobbying operations and formidable political strength, owing to their hefty donations and penchant for hiring former political operatives. Besides, the agencies claim they've landed in their current predicament through no fault of their own. As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.
The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers. In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities.
In the current bailout the Bush administration is playing from strength. Not only have the GSEs' stocks been decimated, but trading in their debt -- whether the $1.6 trillion of corporate obligations or $3.6 trillion of mortgage-backed securities the two have guaranteed -- would have been in disarray had the recent housing bill not made explicit the U.S. government's backing of that debt. Even so, GSE debt spreads are starting to widen, relative to Treasury yields.
An insider in the Bush administration tells Barron's Fannie and Freddie are being jawboned by the Treasury Department and their new regulator, the Federal Housing Finance Agency (FHFA), to raise more equity. But government officials don't expect the agencies to succeed. For one thing, only a "capital raise" of $10 billion or more apiece would have any credibility. Yet, what common-stock investors would advance that kind of money to entities that have market capitalizations of $8.5 billion (Fannie) and $4 billion (Freddie), especially as the FHFA will use its new powers to boost dramatically the regulatory capital the GSEs must have in coming years?
Just as disconcerting for prospective shareholders, all but $300 million of the $7.2 billion in equity Fannie raised in the second quarter was lost in the very same quarter, according to its fair-value balance sheet. With credit losses surging at both agencies, $20 billion in new common equity wouldn't last long.
The cost of selling new preferred stock, meanwhile, would seem to be prohibitive for Fannie and Freddie. The dividend yields on their preferreds have soared to around 14%, in part because of a recent rating downgrade by Standard & Poor's. Yields that high would blight the future earnings prospects of both concerns.