When will the carnage end for Fannie Mae (FNM) and Freddie Mac (FRE) shareholders? After a big sell-off July 7—prompted by an analyst report that the mortgage finance giants could be forced to raise as much as $75 billion in additional capital (BusinessWeek.com, 7/7/08)—the shares recovered somewhat on the following day.
It was only a brief respite. The shares resumed their power dive July 9, with Freddie bearing the brunt of the selling, posting an eye-popping 23.8% decline, and Fannie shares falling 13%. The pain continued in early trading on July 10, with Freddie falling 2.31, or 22.5%, to 7.95. Fannie fell 1.84, or 12%, to 13.47. The latest drops came after former St. Louis Federal Reserve Board President William Poole said the housing agencies were "technically insolvent."
Also, in testimony before Congress, Treasury Secretary Henry Paulson urged Congress to tackle reform of the housing agencies. The Wall Street Journal reported the Bush Administration has held talks about what to do in the event that Freddie and Fannie falter. Officials don't expect the entities to fail, it said, and no rescue plan is imminent.
$3 Billion Issue Spikes Worries
The spur for Fannie and Freddie's latest market mauling came from the bond market. Action Economics reported July 9 that the quasi-private firms' credit-default swaps—which are credit-market bets on the likelihood of default for bond issues—were trading at levels that implied the government-sponsored enterprises' (GSEs) credit ratings should be several notches below the triple-A designation they currently enjoy, based on an implicit U.S. government guarantee of their debt.
Also July 9, Fannie Mae priced a new $3 billion issue of two-year benchmark notes at a yield of 3.272%, marginally higher than the coupon of 3.25%, an indication that investors were demanding a higher yield—and lower price—before they would buy the debt. For a global issue that is very liquid and typically trades in line with the benchmark yield on the note, this was enough of a disparity to spark fear about the difficulty the GSEs may have in raising capital as long as the housing market shows no sign of stabilizing.
When pushing through a deal as big as $3 billion in the current environment with so many investors sitting on the fence, it shouldn't be surprising to see market distortions such as a disparity between the benchmark and actual yields, says Bill Larkin, portfolio manager of fixed income at Cabot Money Management in Salem, Mass.
Freddie Lags Fannie in Raising Capital
The reason Freddie shares fell almost twice as much as Fannie's on July 9 is that the market knows Freddie needs to raise capital by issuing additional equity, says Robert Napoli, an analyst at Piper Jaffray (PJC) in Chicago. (Piper Jaffray received compensation for noninvestment banking services from Freddie Mac within the past year and makes a market in the securities of both companies.)
Fannie and Freddie are trapped in a vicious cycle. The companies will have to raise capital through stock sales, and the multibillion-dollar amounts they have to raise could result in a massive dilution of shareholders' equity. In anticipation, investors have been dumping the shares, driving their prices sharply lower. And the devalued currency of Fannie and Freddie shares means they will have to sell even more shares.
"It appears that stock investors are realizing they will take a back seat to bond holders in the event of any major recapitalization or government injections in the GSEs," wrote Action Economics analysts in a Web site posting July 9.
Although the Office of Federal Housing Enterprise Oversight stipulated that one criterion for reducing surplus capital requirements for the GSEs earlier this year was that the companies raise additional capital, the regulator didn't specify a time frame.
Fannie raised $7.5 billion right away, while Freddie is still waiting to get registered with the U.S. Securities & Exchange Commission, and wants to resolve past accounting issues before it does. In May, Freddie said it planned to raise $5.5 billion through issuing a combination of common and preferred stock.
Too Big to Fail?
"Freddie has enough excess capital that they can wait several quarters before they have to raise capital, unless their [credit] losses come in much greater than expected," says Piper's Napoli.
Anticipation that credit losses will increase is one reason Napoli says he's cautious on the stocks. There are many more U.S. foreclosures to come and home prices keep coming down, so recoveries on foreclosures are going to go lower, he says.
Currently, both companies have sustained credit losses that are less than 0.20% of the total value of their loan portfolios, he says. He believes Fannie can handle credit losses of up to 0.50% of its portfolio, while Freddie's losses would have to be considerably lower than that because it hasn't yet raised the capital it needs.
While it's reasonable to assume that credit losses for the next year won't be more than 0.30% of Fannie and Freddie's portfolios, it's hard to be confident in that number until housing prices stabilize, which is probably another 12 to 18 months off, Napoli says.
With Fannie and Freddie backing an estimated 70% of all U.S. home mortgages, they may indeed be too big to fail—except for their shareholders.