The Fannie-Freddie Frenzy: Pros Chime In
Following the July 13 announcement of a government bailout for beleaguered mortgage finance giants Fannie Mae (FNM) and Freddie Mac (FRE), Wall Street pros and the leading lights of the financial blogosphere have begun to debate what the move means, who deserves the blame for the current mess, and what the future looks like for the two government-sponsored enterprises (GSEs).
What's next for the shell-shocked GSEs, the markets, and the economy? BusinessWeek contributor Jacob Stokes compiled some rather pointed reactions from Wall Street strategists, economists, and key financial bloggers (read BW Chief Economist Michael Mandel's take):
Marc Chandler, global head of currency strategy at Brown Brothers Harriman:
The most important development today is the U.S. Treasury and Federal Reserve's action on Fannie Mae and Freddie Mac, which will either finance or back about half of the U.S. mortgage market. Treasury Secretary Paulson indicated he will seek congressional approval to 1) extend the existing credit line of about $2.25 billion and 2) seek temporary authority to buy stakes in both of the GSEs. For its part, the Federal Reserve will in effect create a new facility so that they can borrow from the Fed at the discount rate and will be given a greater say over the expansion of their balance sheets.
Even though Congress is for all practical purposes in a lame-duck mode, it is likely that the Treasury's request will be added to existing legislation pending and will be approved. In terms of how long the temporary authority is for, the initial thinking is that it could be for 18 months. These actions are thought to be preemptive in nature and to demonstrate support for these important institutions. The hope is that these actions in and of themselves will bolster market confidence without actually having to draw on the new facilities. If the Fed actually were to lend to Fannie and Freddie for anything but the shortest of terms, it would need to be sterilized (offset) through the sales of U.S. Treasury securities. Currently the Fed's Treasury holdings (under the System Open Market Account—SOMA) are valued at about $480 billion (vs. almost $800 billion a year ago). If the Fed needs more than what is available in SOMA, the Fed's ability to control the overnight rates would be reduced.
Andrew Schiff, investment consultant and director of communications for Euro Pacific Capital:
Now that the federal government and the Federal Reserve (which for reasons of honesty and expediency should simply be redesignated as an office of the Treasury Dept.) have announced a bailout of Fannie Mae, and Freddie Mac, the question becomes what is the net effect.… Maybe investors will begin to worry when another bailout isn't necessarily good news? But what happens when the reality of hundreds of billions of new federal liabilities sinks in? Simple answer: higher interest rates and a weaker economy.
A federal bailout of the GSEs will result in a serious degradation of its credit quality. The Treasury's AAA rating should, and will, be questioned. The federal government will then have to offer higher rates to attract investors, especially from the foreign purchases whose participation in the Treasury market is vital.… Given the fragility of the economy and its dependence on cheap credit, higher rates will be the final blow that sends the U.S. into a severe recession.
In choosing to support the collapsing real estate market with a dose of new inflation, the government is keeping home prices from falling further by pushing up prices for everything else. Despite the move, a real estate price collapse is inevitable. So prepare for a dollar collapse and soaring consumer goods prices as the direct consequences of this "bailout." In the end, even those getting the bailout, holders of Freddie and Fannie insured mortgages, will lose, as the value of the dollars in which these bonds are denominated go up in smoke.
Paul Kedrosky on the Infectious Greed blog:
The proposal…has now been announced, and the Administration wants Congress to take it up immediately as part of the current housing bailout package.
So, is it enough? It depends on what you mean by "enough." It will let the market know that the U.S. government is going to let Fannie/Freddie fail, but the market knew that already. Or at least it should have. Beyond that it's awfully hard to say, because markets will mostly read in this what they want to: Bulls will see the U.S. backstopping things, and bears will say the last plank just fell out of the U.S. economy and Dow 8,000 is straight ahead.
These are tough times, folks, and we're headed to a whole new place that has never been explored.
Leigh Skene, a consultant with Lombard Street Research:
Having finally emerged from their accounting problems earlier this year, Fannie Mae and Freddie Mac (F&F), the American giant lenders and guarantors of mortgages, are in the headlines once again. The prices of their common stocks have plunged by 85% and 88% from their highs last summer to yield 10.6% and 12.5% respectively. Clearly markets believe they are in trouble. The questions are, "How much trouble?" and "What does it mean?"
The most important point is there is no imminent threat of default. They are not banks and not subject to runs. Most of the mortgages they hold or have guaranteed are good quality prime conventional mortgages. Their accounting difficulties limited their buying and guaranteeing activities in 2006 and 2007, so they participated little in the worst vintages of mortgages. The default rate on F&F mortgages is low, and income stream from them is currently adequate to meet F&F current expenses. Unlike some other financial institutions, F&F don't have liquidity problems, but they do have significant solvency problems.
Eric Wasserstrom and Robert Peruzzi, CFA, investment research analysts at UBS (UBS):
Although the GSEs had to this point demonstrated no difficulty in raising liquidity, we believe this announcement mitigates liquidity concerns. FRE is conducting a discount note auction today. If the Treasury elects to pursue an equity stake in FNM or FRE, we believe it will do so in the form of a long-dated convertible preferred security. This implies significant common dilution, but is likely supportive of securities above common stock in the capital structure, and gives the GSEs an opportunity to mitigate the dilution through earnings.
We think today's events ensure liquidity for the GSEs, but we remain concerned about dilution until more is known regarding a possible equity injection. Also, given the Fed's long-standing criticism about GSE capital levels, its new consultative role may imply permanently higher levels of capital.
We view Fannie Mae and Freddie Mac's risk as moderate because their implied government guarantees give them the financial capacity to carefully hedge risks while still generating high returns to shareholders. Key risks to our valuation are 1) political: Congress eliminates or weakens the value of their charters; 2) credit: a prolonged national real estate recession; 3) interest rate: a rapid rise in interest rates of 300 bps or more.
Peter Cohan, president of Peter S. Cohan & Associates, on Bloggingstocks.com:
Investors in Fannie Mae and Freddie Mac must be applauding the government bailout. To my knowledge, it is unprecedented for the government to trade this openly in the stock of a private company. It is as if the government has become Goldman Sachs Group (GS), which is not surprising, since the Treasury Secretary, Hank Paulson, used to run Goldman.
Based on what has happened, it looks to me like the Administration is trying to prove just how incompetent government is so we will agree to cut its budget. There are two possibilities: Either the government knew how bad things were and did nothing, or it didn't know. If it did know how bad things were, it should have done something to fix the problem, such as requiring Fannie and Freddie to raise more capital a year or two ago.
Perhaps it knew last week how bad things are and did not release data supporting its claim that they were in good shape because such data did not exist. If they were in good shape, the government should have been able to release comforting data and the problem would have gone away. The need to announce the bailout plan as a way to save them suggests an amazing lack of insight into their ability to cover their liabilities years or a realization that they were bankrupt and needed to be bailed out.
If it did not know how bad things were, that's even more shocking. In either case—it knew and did nothing or it didn't know—the government is exhibiting gross dereliction of duty. But I think its incompetence is demonstrating the need for really capable and empowered regulators. I am hoping America will realize how important regulation is for the effective operations of a free-market economy.
Heidi Moore on The Wall Street Journal's Deal Journal blog:
When it comes to Fannie Mae and Freddie Mac, we have to ask: It is appropriate for regulators to question moral hazard, but shouldn't they also aim those questions of accountability at the consistently bumbling management of the two lenders—which held an implicit government guarantee—rather than shareholders?
After all, it doesn't seem a very strong defense for the government to say, "You should have known better than to have confidence in Fannie Mae and Freddie Mac." The government's involvement was precisely why any shareholder would have faith in Fannie and Freddie. They are, after all, "government-sponsored entities," or GSEs. Paulson used the term—but did not define it—in his statement yesterday.
Consider the uncomfortable truth here: Shareholders bought shares of Fannie and Freddie precisely because they knew that if the two lenders ever fell in trouble, the government would step in. And now that the government has stepped in, it is determined not to help shareholders, saying they should have known better. Well, did the government know better? And if so, why didn't it take action earlier?