Fannie and Freddie: Let’s Call the Whole Thing Off

Fannie (FNM) and Freddie (FRE) are levered more than 50 to 1 (considering their assets on their book, and about 200 to 1 considering also their off balance sheet guarantees). These are levels that would make a Peloton or Bear Stearns portfolio manager blush. 

Consider their precarious situation: 

• They have had a substantial decline in collateral value (house prices) of perhaps well over 10 percent or so, and with an expected further decline of another 10 percent or so (Case-Schiller index figures are higher than these and OFHEO index figures are lower). 
• They have growing default rates and the economy is going through what may be a long and deep recession, most likely the most serious since the 70s, and possibly since the great depression of the 1930s. 
• They have significant exposure to sub-prime and ALT-A (actually several times their equity capital) 
• "Conforming" mortgages were also affected by the lax and fraudulent practices in the mortgage market, so their quality is not as good in the later vintages as it used to be. 
• The mortgage insurers they were relying on to cover first losses were recently downgraded and most likely will not be able to meet the their obligations on all upcoming claims; they are going out of business and will probably become insolvent. 
• Management, particularly FNM’s, has been in a state of denial. 
• Accounting and controls at the firm are still weak. Management seems to be still tempted to window dress; e.g. they've recently changed the way they calculate their loss ratios which makes them look better, and stopped buying the portfolios of defaulted mortgages for which they provided guarantees to avoid recognizing losses upfront; they now provide the guarantee payments to the holders of the MBS on an as-needed, ongoing basis, and they have not written down their investments in equity in affordable housing tax credits, which the company can only take advantage of if it has profits

The compounded affect of all these adverse elements, particularly the increase in default rates coupled with falling collateral and the weakness in the mortgage insurers, leads to an exponential, not linear, increase in losses for the agencies. 

So the equity market value of the housing agencies, Fannie Mae and Freddie Mac, continues to get smoked, with a 15%+ drop yesterday. I fully expect, with over 90 percent confidence, that FNM and FRE shares will end up virtually worthless in the coming few months (they are no more than a deep out-of-the-money call option).

Given that these entities, with a current combined equity market value of about $25 billion, are supporting a book of mortgages of about $1.5 trillion and over $4 trillion of guarantees (so with ratios of equity to assets of 1.5 percent or 0.5 percent, respectively), it follows that they will have to raise substantial amounts of equity to rebuild their capital bases, perhaps as much as $50 billion each, possibly more.

Now who would be willing and able to invest such large amounts at this stage? The New Jersey investments division?... 

The answer is no one - except the US tax payer. I suggest that rather than trying to throw sand in the eyes of the public and come up with a more aesthetic solution, the government should just look at an outright nationalization. The agencies experiment did not work; let's call the whole thing off.  Equity holders should be wiped off, and perhaps debt holders should take a very modest hair cut (say 5-10 percent of principal). 

This solution would presumably allow a full recapitalization of the agencies, an improvement in their ability to do business and contribute to avoiding an overshooting on the downside of the decline in housing prices.  It would also allow the government and the tax payers to fully participate in any upside of the agencies' business. To paraphrase Dave Einhorn : “No more private profits and socialized risks”. 

Disclosure: Author holds short position in both FRE and FNM

Comments

[RichardSchweitzer]

Absolutely on target. This would also end one of the most corrupting synergies in politics.

The impact would be more effective and far-reaching than the proposed "Housing bailout," and have a much lower long-term cost with lower "moral hazard."

[rm]

Don't you understand that the additional oversight provided by the Foreclosure Prevention Act will fix everything?

[carey_jim]

If these two agencies were completely controlled and run by the US Government, could they possibly be less efficient and effective?

[Tom Lindmark]

Good article, but why should the debt holders take a "modest" haircut? Why not go through a BK and let the chips fall where they may.

[Reinko]

In the spring of 2004 I already warned against weird business models like Freddie and Fanny have; they only pick up one kind of risk and after that accumulate gigantic amounts of that.

Same thing for the bond insurers; also a nutty business model in a price driven competition environment.

It was only waiting until the thing blew up, it was a long wait but I am very satisfied to see my insights coming out in detail...

[mallarde]

The hybrid public/private form of these entities is absurd. Only the two-dimensional mind of George Bush and the opportunists that surround him would advocate for such a stupid thing.

Either it is a for-profit venture weighing risk and return or it is to serve the public interest by supporting the mortgage market. One or the other.

[redriver]

I don't like George Bush. I didn't vote for George Bush.
But, "Its George Bush's Fault!!!!?????????&quo... God that's so old.

So for a dose of the truth here's " Taking you back to school", again:

Fannie Mae was created in 1938 as part of DEMOCRATIC PRESIDENT Franklin Delano Roosevelt's SOCIALIST New Deal. (Read, The Forgotten Man) The collapse of the national housing market in the wake of the Great Depression discouraged private lenders from investing in home loans. Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.(Sounds familiar, Socialists drooling now)

Initially, Fannie Mae operated like a national savings and loan, allowing local banks to charge low interest rates on mortgages for the benefit of the home buyer. This lead to the development of what is now known as the secondary mortgage market. Within the secondary mortgage market, companies such as Fannie Mae are able to borrow money from foreign investors at low interest rates because of the financial support that they receive from the U.S. Government. It is this ability to borrow at low rates that allows Fannie Mae to provide fixed interest rate mortgages with low down payments to home buyers. Fannie Mae makes a profit from the difference between the interest rates homeowners pay and foreign lenders charge.

For the first thirty years following its inception, Fannie Mae held a veritable monopoly over the secondary mortgage market. In 1968, due to fiscal pressures created by the Vietnam War, DEMOCRATIC PRESIDENT Lyndon B. Johnson privatized Fannie Mae in order to remove it from the national budget. At this point, Fannie Mae began operating as a GSE, generating profits for stock holders while enjoying the benefits of exemption from taxation and oversight as well as implied government backing. In order to prevent any further monopolization of the market, a second GSE known as Freddie Mac was created in 1970. Currently, Fannie Mae and Freddie Mac control about 90 percent of the nation's secondary mortgage market.

GSEs such as Fannie Mae and Freddie Mae, with their combination of private enterprise and public backing have experienced a period of unprecedented financial growth over the past few decades. The current assets of these two companies combine for a total that is 45 percent greater than that of the nation's largest bank.

On the other hand, their combined debt is equal to 46 percent of the current national debt. It is this combination of rapid growth and over leveraging that has lead to the current concerns of Congress, the Justice Department and the SEC with regards to the financial practices of these GSEs.

Fannie Mae and Freddie Mac are the only two Fortune 500 companies that are not required to inform the public about any financial difficulties that they may be having. In the event that there was some sort of financial collapse within either of these companies, U.S. taxpayers could be held responsible for hundreds of billions of dollars in outstanding debts. A recent investigation by the Justice Department and the SEC into the accounting practices at Freddie Mac revealed accounting errors in the amount of 4.5 to 4.7 billion dollars and resulted in the termination of three of the company's top executives. Ongoing investigations by DEMOCRATIC CONTROLLED Congress, particular the DEMOCRATIC CONTROLLED House Finance Services subcommittee that oversees the activity of GSEs, will determine the future role of Fannie Mae and Freddie Mac and the secondary mortgage market that they dominate.

Just the facts.

The Obama camp can now formulate a response.

[Think-About-It]

Thanks Redriver... good history.

[Wez]

Lol, "equity holders should be wiped off"...that statement, with you short these stocks, just killed any attempt at discussion.

[ksmithdc]

We need to take a good hard lesson from this mess and do a complete overhaul of the laws governing the mortgage industry. The mortgage people & bankers didn't care if they were selling loans to people who didn't qualify. So long as they made their commission, who cares? Then when the inevitable foreclosure happens...well they stand to profit once again. It's sad.

[Just SomeGuy]

Lot of those bonds, and maybe stock, in the widows and orphans funds, direct or via funds. Taxable, can take a writeoff, get a third of the haircut back. IRA's, not so pretty.

[icandoitdon]

"Fannie Mae and Freddie Mac are the only two Fortune 500 companies that are not required to inform the public about any financial difficulties that they may be having."

this is utter nonsense. they are subject to the same rules of SEC and GAAP accounting as every other fortune 500 firm.

[johngonole]

I agree with Tom Lindmark. Let the stockholders and bondholders suffer. The taxpayers should not have to pay for one more bad socialistic scheme turned into a fascist scheme. Once social security and medicare fail Rosy's failures will be complete.

Its time to turn from the dark side and level the playing field and return to free markets. Its time to tear down these financial fascist constructs and set people free. Not only that.....I'm not sure I agree with this myself....but I also think it might be time to go back to real paper money backed by the governments assets such as gold, real estate, etc... We also need to real in fractional reserve banking. The idea that monetary policy can control the markets and prevent recessions is a bad idea because it depends on the expansion and contraction on the money supply which is the same thing as saying the expansion and contraction of debt. When they want to prevent recessions they encourage people and businesses to go into debt. It really doesn't make much sense. A little debt is OK but when the whole financial system is built upon it we will always run the risk of finanical collaspe. The dollar should respresent tradeable hard assets not debt promissory notes.

[Anil]

Sadly - This is true. Government is also engaging in deception by not nationalizing and informing tax payers of the obligations/bail outs assumed on behalf of citizens.