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Freddie & Fannie
Market Comment, 9/7/2008
Yahoo Weighs Microsoft
Bid: To Do, or Not To Do?
FREDDIE & FANNIE: NOT TO WORRY, YOU’RE JUST A LITTLE PREGNANT (i.e.
bankrupt)
September 7th, 2008
FREDDIE & FANNIE LIKELY TO DOMINATE THE MARKET THIS WEEK
Our Risk Premium model suggests that stocks are headed for a negative
inflection point based on value in the days and weeks ahead.
Nevertheless, the markets are apt to be dominated by the not
totally unexpected news from Treasury Secretary Henry Paulson that the
government was, with immediate effect, taking over Freddie Mae (FNM) and
Freddie Mac (FRE) by placing both institutions under the jurisdiction of
a “conservator.” (...
appointing a “conservator” is not a positive event). Ongoing
operations will continue as normal
(...well as normal as things can be expected from this
situation) and be run by the Federal Housing Finance Agency
(FHFA), the new agency created by Congress this summer to regulate
Fannie and Freddie.
Paulson stated that placing the troubled financial
giants under government control was necessary for “market stability,
mortgage availability and taxpayer protection.”
And we feel these goals, over time, will be substantially be
realize. This should not be viewed as a government bailout, since the
“price” of recasting FNM and FRE will be absorbed by investors,
especially common and preferred shareholders. The two financially
distressed institutions, which
have long played an outsize role in the mortgage market as
sponsors or underwriters of over half of U.S. home mortgages, were, it
was feared, heading on a dire path for the U.S. and world economies.
Hence, it was imperative that the government act to restore
market confidence in the two entities whose debt and securities are
widely held around the world.
MARKET SPILL- OVER EFFECT ON FINANCIAL INSTITUTIONS
There is little doubt that the government “conservatorship” will give
a momentary boost to the stock market especially the financial sector.
Once investors, however, have had a chance to pick through the
details of the Fannie Mae and Freddie Mac takeovers, we suspect the
excitement will gradually die down
(...the devil is always in the details). Stocks in the
financial sector, predictably, should be caught up in the euphoria of
the moment. While this plan had most of the makings of an out of court
reorganization (the precursor of a bankruptcy), if approved by Congress,
it can alleviate FNM and FRM’s over-extended balance sheets
(...that’s what reorganizations and
bankruptcies are for!)
COMMON & PREFERRED SHARES IS NOT LOOKING PROMISING “RIGHT NOW”
Regarding the Fannie and Freddie takeovers, the Federal Reserve and
Treasury announced that the FHFA is "prepared to work with these
institutions to develop capital-restoration plans.”
While senior and subordinated debt and mortgage backed securities
will be honored, dividends on common and preferred shares will be
suspended, saving the institutions over $2 billion in capital a year.
The common and preferred shares will continue to remain
outstanding. As of June 30th,
2008, they had nearly $36 billion in preferred shares outstanding.
Together, Fannie and Freddie own or guarantee more than $5
trillion of U.S. home loans, about half the total outstanding mortgage
debt in the country.
THIS IS HARDLY A TAXPAYER BAILOUT
Recovery prospects for shareholders would not be helped by
allegations that this is, per say, a taxpayer-funded bailout.
Shareholder recovery prospects weren’t helped by comments by the
two presidential candidates.
Senator Barack Obama said that the rescue "must protect taxpayers, not
bail out the shareholders and management of Fannie Mae and Freddie Mac.”
Sen. Obama went on to say that: “Any action we take must be
focused not on the whims of lobbyists and special interests worried
about their bonuses.”
Senator John McCain said the two institutions had "gotten too big and
too expensive to the taxpayers.”
His vice-presidential running mate, Alaska Governor Sarah Palin,
added that: "A McCain-Palin administration will make them smaller and
smarter and more effective for homeowners who need help.”
Finally, the takeovers will face immediate scrutiny from Congress
as it returns from recess this week and, hence, will travel through the
high of the political process, which cannot ignore revisions desired by
the new administration. Bipartisan support is expected
(...yet, while both parties may be
“on the same page, let’s hope they’re reading the same book.)
NOT TO WORRY: YOU’RE JUST A LITTLE PREGNANT (i.e. bankrupt)
In the corporate world, this takeover situation would be akin to
pre-bankruptcy. Common and
preferred shares of Fannie Mae and Freddie Mac will remain outstanding
and continue to trade on the open market.
(...yes, until such time as the “conservator” deems
that the asset base cannot generate enough cash to satisfy these
security holders.) Meanwhile, corporate operations will
continue as usual under the direction of the conservator and until such
time as FHFA has determined that the two companies “are stabilized.”
Officials announced that the chief executives of both
institutions had been replaced.
Herb Allison, a former vice chairman of Merrill Lynch, was
selected to head Fannie Mae and David Moffett, a former vice chairman of
US Bancorp, was picked to head Freddie Mac.
(...it’s obligatory to oust the senior most Official
regardless of their culpability!)
OPEN MARKET PURCHASES: A BIG NEW BUYER ENTERS THE MARKET
FHFA intends for the Treasury to purchase mortgage-backed securities
from the firms in the open market through a Treasury lending facility
from general funds held at the Federal Reserve Bank of New York.
For holders of these securities an open market the repurchase
strategy is a positive – yet there is the unpleasant question of what
market prices these securities can and will be purchased for.
Nevertheless, since Fannie and Freddie will be operating as
“real” companies there is good reason to believe that their purchases
will be at “opportunists’ prices” (i.e. not necessarily face or
redemption values). Knowing that the U.S. government plans to buy
securities in the open market should provide a strong bounce to those
asset-backed obligations which have been under pressure.
FREDDIE & FANNIE’S
IMPORTANCE TO THE HOUSING AND CREDIT MARKETS
Federal Housing Finance Agency (FHFA) Director
James Lockhart, who was appointed conservator of Fannie Mae and Freddie
Mac and who will oversee them, said the purpose of the takeover was to
restore the companies to a “sound and solvent condition.”
He noted that the two government-sponsored $5.4 trillion
enterprises had held over 80 percent of all new mortgages earlier in the
year but that as their financial conditions deteriorated investors had
lost confidence in their ability to cover their obligations,
jeopardizing their access to the capital markets.
Fannie’s and Freddie’s high capital costs meant “that virtually
none of the large drop in interest rates over the past year has been
passed on to the mortgage markets,” Lockhart said, thereby reducing
their ability to provide affordable housing, as they are obligated to do
by their government charters.
The government takeover and supply of capital, it
is hoped, will calm markets and stabilize the housing mortgage market,
if not begin a long and labored road to recovery. Fannie and Freddie
will be allowed to modestly increase their mortgage-backed securities
portfolios through the end of 2009.
Beginning in 2010, however, the portfolios would be gradually
reduced at the rate of 10% annually, including a natural run-down of the
portfolios.
In anticipation of a government-sponsored reorganization plan, share
prices for Fannie Mae and Freddie Mac declined 21.9 per cent and 20.9
per cent respectively in after-hours trading on Friday, reflecting
investor concerns that the rescue plan would wipe out holders of equity
while guaranteeing their debt. In our Risk Premium report last week,
entitled, “This Market Is Not On Auto Pilot, Yet,” we expressed concerns
about how Preferred Shares would be viewed under any restructuring plan.
Right now, they are rapidly approach zero or
nominal value, but as in any “reorganization,” everything becomes
open to negotiation
(...this one promises to be
especially interesting since the government is involved and the public
pronouncement could be different from the true economic recovery for
shareholders.) n
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