Beware of Sending Fannie and Freddie Stock to Zero

The press and many professional stock analysts are predicting that Fannie Mae’s (FNM) and Freddie Mac’s (FRE) stock price will go to zero in a government bailout. The level of fear is so intense that the shorts have hit without caution. At the same time, the press and Wall Street professionals are saying bondholders will be safer with a government bailout. Nobody really knows what form a bailout would take or even if one is necessary. But we are being told to watch the Freddie Monday debt offering intently for clues.

While I think most of the fear mongering is engineered by the shorts, I don’t know if the GSE’s “accounting insolvency” will become a real liquidity crisis. Remember that the GSE’s only guarantee a stream of payments, not immediate payout on default. Write downs and cash flow are two entirely different things.

Let’s say the basis for fear is sound and the Treasury opts to kill the Fannie and Freddie equity. How does this affect the rest of the banking system? This would be the second bailout under Treasury Secretary Paulson’s “moral hazard” rhetoric. Just like Bear Stearns (JPM), Paulson would want to make sure that Fannie and Freddie equity holders are hurt. What would stop him?

All this rush to judgment is forgetting that once even one more pivotal financial institution’s shareholders are wiped out, no other financial companies will be able to raise capital. The fear of equity investors would be so great that Citibank (C), Lehman (LEH), Merrill Lynch (MER), and even venerable JP Morgan (JPM) will completely lose access to raising new equity. What’s more, current outstanding equity prices will plummet. Paulson cannot afford this level of moral hazard.

Paulson is being awakened to the need to balance moral hazard with building confidence. Too much moral hazard and banks, along with the GSEs will be forced to shrink their balance sheets. This will further apply the brakes to the economy. I believe Bear Stearns was enough moral hazard; now is the time to rebuild confidence.

Two proposals that surfaced in the press that make sense: the Treasury buying GSE preferred stock and the Treasury or Fed extending a line of credit to the GSEs. The Treasury purchase of convertible preferred stock would create a major delusion, but current shareholders would still be able to participate in the recovery. Opening the discount window or expanding the Treasury’s line of credit would instill immediate confidence in the GSE debt. Both of these actions would allow the GSEs to return from technical insolvency.

The worst moral hazard would be to put the GSEs into receivership. Then the government would equate GSE debt with treasuries. This would give Congress free will to use the GSEs to promote social policy with no constraints, and substantially grow the public debt. No conservative administration can take comfort in this.

I am sure Paulson does not want to constrain the entire banking system to teach Fannie and Freddie shareholders a lesson. The GSEs might never have to access the line anyway, but just having it would actually kill the shorts. The side effect might be to save Lehman too.

Disclosures: Author is long C, FNM, FRE and JPM.

Comments

[sr9web]

While we may all be under "major delusion", I'm pretty sure what you are worried about is major "dilution" - but I have been wrong about things like this before...

[SomethingbeforeMonday]

They need to do something before Monday because it will be even more chaos and make the BSC situation look like a drop in the bucket.

[Ishortyou]

Looks like on Monday a lot of panic is going to show up in the banks front desks.

[J D Cruz]

I'm not sure I understand why Paulson would want to "teach Fannie and Freddie shareholders a lesson". Is that because he thinks that all FNM and FRE shareholders are buying just because they think the two GSEs are going to be bailed out by the government? What about those shareholders who have had shares long before this economic mess started?

[xsuddensam]

The conservatives are always crying about government regulation and involvement in the market. Their theory is that the market will take care of itself. However, if it's their money at risk, they are the first to get in line and scream the loudest.

If one invests in the market, it's no different than gambling. One pays for bad decisions. There should be no bailouts whatsoever. Let the market take care of itself ;-) no matter how much it hurts. Printing more money (liquidity) is no solution. It's just postponing the inevitable--the total collapse of the financial system.

[Bkraswting]

On Friday the recently issued Preff issue of FNM (8% coupon issued 5/08) was trading at 13 to produce a yield of 16%

The GSE can not borrow preff money at 16. It will just add to their losses.

If Treasury buys a $10b Preff with a coupon of 4% then Paulson will have failed the moral hazard test.

Lets face it. There is no "market solution". There is no level of Government support that does not meet the definition of a moral hazard.

If there is a big subsidized preff deal it will have to done with the stock at near 0. Sorry.

[mwphnh]

You are 100% correct. The govt doesn't have to buy anything; just say we will not make them raise any common here...that we will let them sell preferred only for the next year or two with the promise to do common when the smoke clears. This is all about confidence as the situation; whatever it is; did not deteriorate that dramatically in the last 40 days. In the very 1980's the govt gave loan guarantees in exchange for warrants to Chrysler. The govt made a ton of money and saved the company. FRE/FNM are 100 times as important as Chrysler so I see trhe saME RULES APPLYING HERE. Placing the GSE's into conservatorship would be an unmitigated disaster and paulson - and i am saying this as a former GS employee - cannot be that stupid.

[AlanBrochstein]

I was thinking about the Chrysler analogy as well, and question your assertion that FNM/FRE are 100 times as important. I was thinking 1000!

Conservatorship isn't an option. Opening the discount window and purchasing warrants, if necessary, are very low-risk, low capital commitment options.

Saving the debt holders of BSC was a step to prevent counterparty risk explosion. Saving the debt holders of the GSEs is of international importance. Ironically, everyone talks about how the equity holders should take the hit. It's a joke. Yes, the public has pulled out some dividends, but any long-term investor in the GSEs hasn't exactly done very well. On the other hand, the cumulative gain over the years by those who have collected the extra yield for an implied vs explicit guaranty has vastly dwarfed any returns to equity investors (in dollars). No one will ever by GSE stock again if they zero FNM/FRE.

[AmesTiedeman]

FNM and FRE will not be allowed to fail. Period.

[borisb]

FNM and FRE have lower default rates that the questionable aggressive lenders. If, and i am assuming they have, done mostly what they were suppose to do, they deserve a second chance.

[captbob]

The Investment bank of last resort is the Fed.
But they must have a good "Humanitarian&quo... reason to appease Congress on a move of this magnitude. Bailing bankers with tax dollars is getting unpalatable.

The poison pill in the whole mess are sub-prime mortgages. They were created by greedy bankers but now they bite all who touch them, bankers and unsophisticated/innoce... homeowners alike.

I believe Congress will create a "Homeowner safety net". The houses are built, bought and paid for. To toss families in the street and create deteriorating, vandalized, vacants, exacerbates the loss. At best the are auctioned for 30% of value, depressing 100% of the market Nationwide.

This "safety net" will funnel the loss difference from the fed to Fakee & Foolie to take over and rewrite the mortgages in a manner the occupants can afford-(with pain attached). The phonies-(application liars and speculators , for resale) will be sold off in a trickle the market can absorb.

This of course will require Zimbabwe Bennie to go for an advanced course in turbo charging a printing press. And will result in the dollar going from medium/rare to well done in the cooked dept.

But no matter how you turn it, there are only fiat dollars in the lifeguard tower. Might as well make some political hay out of it, that will fool most of the people most of the time. And give the other big banks--(their buddies) a chance at a Phoenix resurrection, by unloading a PORTION of their stink on Fric & Frack.

[karmaguy]

Good points made by Captbob. From an investment point of view as to how you play this to your personal advantage, then one thing seems certain - no matter what the government does (and it will do something) the net loser must be the U.S. Dollar. Therefore, all those things that have gained in the past when the Dollar has fallen will be the ideal Longs as they have been for the past few years,

[max marx]

from them that has it to them that ain"t.

[delta7777]

Freddie&Fannie into receivership????????
can you spell...b.a.n.a.n.a......
Hugo Chavez would get a real kick out of this one----
nationalize the losers, not the winners???
(we don't really grow enough bananas)

[User 224526]

How in the WORLD can you be LONG on FNM, FRE!!????!

We're talking about the same company, Fannie Mae, who restated earnings by $6.3 billion!!!!

The restatement for 2001 through June 30, 2004, made public on Wednesday, wiped out $6.3 billion in profit for the government-sponsored company, which finances one of every five home loans in the United States. Ordered by the government two years ago, the massive reworking of its accounting has cost the company some $1 billion this year to carry out.

You actually believe ANYTHING this PIG has to say? If you're not shorting this to ZERO, I'm glad you're happy to be the bag holder.

[delta7777]

see:

market-ticker.denninge...

[Silverback]

We will all be much happier in the Socialist system being prepared for us. We will get great satisfaction knowing that our efforts are advancing the State.

Choose your favoite broom or shovel, you will be told where to go.

[delta7777]

delta 7777

link does not post--for thoughtful article, Google:

market ticker denninger fannie freddie

[the omega]

Great take. The blog psychologyofthecall.bl... has a very similar take, this whole thing is a political noose around the shorts necks at this point, the trigger finger is readied and steadied ...

[icandoitdon]

the author makes one good point, whether intended or not. there is no way out of this mess unless you believe, as some do, that it is merely a "crisis of confidence." anyone who believes that listens to too much larry kudlow and phil graham.

we have a structurally flawed economic model that relied on cheap, plentiful credit and excess leverage. those days are over brother and that's what the shorts can see that the eternal optimists can't. more power to them...it was a bad model from the get go and it deserves its fate.





isn't that a fact?

[User 30121]

To: icandoitdon

You are CORRECT!

[glassbox]

You are right that the current fear in equity 'long' investors is so intense that there could be spill over effect to the other financials and that likewise the equity 'short' destroyers (I won't even call them investors) are having a field day. There is something Paulson can do for starters - regulate the disclosure in short selling and subject the short sellers to the same standards as the longs. In bloomberg, I can see who holds a stock (e.g. a fund or major shareholder) but I cannot see who shorts a stock. Also, I think its very important also that all longists should know who is borrowing their stocks rather than allow it to be pooled by some custodian bank to be lent out.

Its high time real investors come to realise who is at the short end of the this lousy deal that the investment banks/custodian banks are giving all in the name of 'free market enterprise'. Meanwhile, the shortist (many of whom are really smart) are just exploiting this asymmetry.

[Bob Gary]

They won't go to zero. They get bailed out before that happens. IMHO.

[sammy so]

Is Paulson crazy? Doesn't he realize what a collapse of FNM & FRE could mean? I don't understand how someone who headed Goldman could be so ignorant of basic economics.

[Vikram12]

Let me introduce you to a concept called distressed Equity valuation. Equity of distressed companies are valued as call options with strike being the face value of debt, and maturity being the weighted average duration of debt. Even if market value of assets are less than the face value of debt corporations have possitive stock prices. There is nothing called zero stock prices unless liquidation... Since assets are volatile call option prices will comand some value till the debt maturity is due.... Zero is not going to happen so soon....

[Vikram12]

Let me introduce the concept of distressed equity valuation. The equity holders are valued as a call option with face value of debt being the strike and weighted average duration of bonds being the maturity of the option. Even if market value of assets are less than the face value of debt, the equity does not trade below zero. the assets = liability + SE equation... A simple concept which says equity holders are liable to only the ammount of equity invested. This is because the underlying asset which is the firm has volitilty and the debt has time till expiry which increases the value of the call option... Investors look at distressed corporations this way... These companies cannot turn zero so fast unless there is a complete liquidation and the concept of a ' going concern' is defeated....

[MichaelSteinberg]

Sr9web: I stand corrected. I updated my blog, but have not requested SA correct this post.

Bkraswting: Please be careful in evaluating FNM/FRE preferreds. Many are not cumulative and only hold their fixed rates for a limited amount of time. Long-term buyers of the preferreds will then be paid variable rates.

[icandoitdon]

glassbox:

shorts have more to lose than longs if they make the wrong bet.

we have a financial panic and you can't blame short speculators for taking advantage any more than you can blame long speculators for piling into oil. don't blame the shorts. blame the regulators who are supposed to safeguard the financial system, primarily the federal reserve.

[swaps]

On Sunday afternoon I have the advantage of learning that Freddie and Fannie will be able to go to the discount window and borrow cheap money, just like the privately owned retail and investment banks can do.

This makes sense. Our entire economy and way of life is now financialized. Next, Macy's and Sears will be given access to the discount window.

Conceivably a decade down the road, every U. S. citizen and illegal immigrant will be given access to the discount window too. After the last vestige of free market Darwinism goes extinct.

I would say that the shorts will be covering Monday, but you deeper thinkers and hands on Wall Streeters have a better inside feel.

Dan

[glassbox]

icandoitdon, I think you are missing my point. I am not blaming short speculators for taking advantage. I am saying that the current framework in which they operate gives them an upper hand in secrecy vs the long. For this, it is the regulators who need to ensure a level playing field. These are loop holes that they are using to speculate in manner which don't give a chance for logic to prevail and stoke fear and uncertainty in a highly unstable and unfair manner.

Whether the shorts have more to lose than long - I don't particularly care. I just don't like the way I am not being able to see who the players are.


On Jul 13 05:26 PM icandoitdon wrote:

> glassbox:
>
> shorts have more to lose than longs if they make the wrong bet.
>
>
> we have a financial panic and you can't blame short speculators for
> taking advantage any more than you can blame long speculators for
> piling into oil. don't blame the shorts. blame the regulators who
> are supposed to safeguard the financial system, primarily the federal
> reserve.

[icandoitdon]

glassbox:

yes, i see your distinction but i'm not sure it matters. it's not like admitting to boning somebody's wife is it? hahaha! oops.

[Did U ThinkThe PonziSchemeWould Last?]

Sending them to zero?? They are worthless already and only a fool invests in something with negative value. The fed of 1929 also jawboned about market support but the market is far bigger than the fed and I 100% guarentee you that at some point they will just step back and let it crash so they can (with a tear in their eyes) pick up all the pieces at the bottom fire sale prices and below.

The whole thing has been engineered. Banks make up "money" from thin air - they don't earn it. When a loan goes bad the bank loses nothing because it never had anything in the first place. The illusion is pure alchemy and the people of the US need to wake up and abolish the fed AND fraction reserve banking. If you have to finance the growth with vapor then the growth never was sustainable.

Fannie and freddie are dead, and so are many other companies and most investors too.

[glassbox]

icandoitdon

I think that distinction matters. This is because if I am a shareholder of a company and I know who has been shorting the stocks, I can choose to decide if I want to lend him stock.

The problem with today's market is that most longists have been quite idiotic lending stock to the shortist - its like I lent you my gun to only have you turn around to shoot me back.

Let's see what happens when all shareholders decide to withdraw from all stock lending agreements.


On Jul 13 08:58 PM icandoitdon wrote:

> glassbox:
>
> yes, i see your distinction but i'm not sure it matters. it's not
> like admitting to boning somebody's wife is it? hahaha! oops.