More Negative Press for Fannie and Freddie

Last week former Federal Reserve Chairman Alan Greenspan strongly criticized the form of the Congressionally mandated Freddie Mac/Fannie Mae "backstop" program and a survey by the Wall Street Journal found that a small majority of economists involved thought the bailout of the two government sponsored entities (GSEs) would ultimately be invoked, handing taxpayers responsibility for their $5.2 trillion debt.

Monday the stock market began to take the rumors seriously and Fannie Mae dropped 22.25 percent ($1.76) of its value to $6.15 per share while Freddie Mac lost 1.46 (24.96 percent,) falling to $4.39. Yesterday's close represented enormous losses over the last year when Fannie and Freddie were trading for $70.15 and $65.88 respectively.

What was worse, the entire market followed Fannie and Freddie down the tubes Monday with the Dow Jones finishing the day off over 180 points. The market was tanking again on Tuesday with the Dow off 126 points at 11 a.m.

Meanwhile, more voices were added to the chorus of experts and pundits predicting that government intervention will be required.

Randall W. Forsyth and Jon Laing, writing separate articles for Barron's.com, spoke of the inevitability of a bailout and the dangers the action would carry with it. The Barron's articles (identified thus because Forsyth quoted extensively from Laing articles and we may not always have sorted out the quotes correctly,) reminded investors that government investment would almost certainly wipe out the equity of common stockholders and take a large bite out of the $14 billion held by preferred stockholders and also holders of subordinated debt.

However, maintaining the viability of Fannie and Freddie must be insured because their securities account for an estimated $1.5 trillion in assets of overseas central banks so a failed GSE debt auction would be global and catastrophic.

Also, the two GSEs now provide the funds for most new mortgage credit as the private mortgage-backed securities market has disappeared and banks have cut the availability of any type of mortgage loans, even prime loans which are also increasingly seeing borrow defaults.

"The question is when, not if, the federal government will have to bail out Fannie and Freddie. Most likely the Bush White House would want to leave it to the next administration. Whether the market will cooperate is another matter."

The cost of insuring the subordinated debt has increased so much that it is unlikely that a bailout would include it. Fannie and Freddie CDS were quoted at 330 basis points, up 50 basis points Monday, equal to a cost of $330,000 to insure $10 million of their debt.

The cost of issuing new preferred stock would also seem prohibitive for Fannie and Freddie. The dividend yields on existing preferred stock have soared to around 14% and such yields would blight the future earnings prospects of both concerns.

Both GSE's were agreeable last winter when they were asked to raise more capital, although they did convince their regulators to delay the auctions a few months. In the spring Fannie performed as agreed, raising $7.2 billion in mostly common equity, but Freddie failed to live up to its promise to sell $5.5 billion in equity.

Freddie's president Richard F. Syron offered a variety of excuses: senior board members did not want to dilute current shareholders because the stock had already fallen from $67 to $25 in less than a year; Freddie could do nothing on the core capital front until it had completed its formal corporate registration with the SEC under the 1934 Act (Freddie had raised $6 billion in preferred capital the previous November in identical circumstances.) Now Syron says that they are waiting for a more "propitious" to raise the funds. Barron's argues that May might have presented better timing when the stock was selling for $25.

While regulators were listening to the excuses, Freddie was busily obtaining even more mortgages. Its retained portfolio increased by 11 percent in the second quarter. In retrospect, the agency meltdown seemed inevitable as the housing crisis deepened and credit losses mounted.

"Should the agencies fail to raise fresh capital, any cash infusion from Treasury is likely to take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends," Barron's said.

Lawrence Summers, former Treasury Secretary in the Clinton Administration and economic advisor to Barack Obama feels that both GSEs should be thrown into government receivership to protect taxpayers while John McCain argues that not a dime of taxpayer money should be used to bail them out and that the management and boards should be replaced and their huge salaries drastically cut and bonuses eliminated.

Barron's notes that the true market worth of each corporation may now be as little as a negative $50 billion and they have little prospect of digging themselves out of the hole. Whether Fannie and Freddie are liquidated or nationalized as a prelude to privatization, in their current form they won't be missed."