Time to Change GSEs' Deal with Treasury

Given Freddie Mac’s (FRE) recently reported profitable second quarter earnings, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae (FNM) and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.

Reasons to Change Fannie and Freddie’s Deal with the Treasury

1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut four weeks before TARP.
2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson and Fed Governor Kevin “Hey, Brah” Warsh.
6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock. It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios.
9. GSE preferred stock is still primarily owned by small banks. When dividends are restored, the value of the preferred stock will increase by 10x. This will add approximately $30 billion in restored capital to the commercial banking industry. If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.

Terms to Change

1. Lower preferred stock coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point. We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.

The GSEs' deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.

Disclosure: Long FNM preferred and FRE preferred, No position in FNM or FRE common

Comments

[stevey:]

Very compelling arguments supported by facts.

Aug 26 08:39 AM

[y2kurtus:]

Every debt security issued in the last 10 yeasrs by FNM FRE and even the FHLB for that matter has stated on the cover page "THIS SECURITY IS DEBT ONLY OF THE ISSUING AGENCY AND IS NOT GUARENTEED BY THE TREASURY OF THE UNITED STATES OF AMERICA."

This is why agency debt trades at higher yeilds treasury debt dispite frantic buying buy the fedaral reserve. The minute that bond buying stops spreads revert to market levels... and home loan rates rise.

Good luck to those whishing for the federal goverment to admit they made a mistake when suspending preferred dividends on FRE and FNM... I view that as a highly unlikely outcome.

Aug 26 03:36 PM

[Johnc222:]

Amen...!!!!! The United States Government did not take a stake in these financials to make money,...that wasn't the primary intent.

The intent was to shore them up until they could get back onto their feet. The U.S. should NOT...be taking a DIVY from... FRE, that money should stay at FRE and be used for operations.

Doesn't make much sense to be taking Capital from the GSE and shoring them up at the same time. The USA doesn't need the 1.1 billion in Divy's . What the USA needs is a strong and healthy Dealer in the mortgage markets.

So, it's time for the Treasury to convert the prefers into common equity.

Aug 27 08:49 AM

[Bruce Krasting:]

Agree with you on the Pref over common. There has to be a resolution of this. Did anyone notice that 1mm Fre-X traded in the pre market? Similar thing happened yesterday. This stuff never trades pre market. Who's buying 1mm blocks this early? Who's selling? Why pre market?

Aug 27 09:32 AM

[mateintwo:]

I made similar comments on the Yahoo FNM FRE boards after TSY put the GSE’s into conservator ship and after AIG was allowed to renegotiate their terms including interest rate paid and nothing was done for GSEs my blood really started to boil. The biggest injustice is that also the share holders’ rights of F&F were completely cancelled. But still how can TSY with a straight face give the crooks at AIG a better deal than F&F?

F&F in a sense saved America because if we would not have had them the C and BACs of the world would have had a vastly higher mortgage exposure and even though F&F made some mistakes it dwarfs in size and extent of what private banks committed.

Aug 27 09:59 AM

[c smith:]

ANYTHING which keeps FNM and FRE out of runoff mode is a decidedly BAD idea. Wean the U.S. housing market away from these two miscreants over the next 5 to 10 years and put them both out of our misery as taxpayers.

Aug 28 04:07 PM

[Tom Jacobs:]

It is like you stepped out of a time machine, completely ignoring Fannie and Fred's lengthy history of using lobbying to castrate any politician who dared suggest that their excessive risk taking and implicit government guarantees put tax payers at risk. Unbelievable.

Aug 28 07:29 PM

[Jim Dwyer:]

Phonie Mae and Fraudie Mac shareholders are like the people who jump on the city bus after it's been in an accident, hoping to sue the city for whiplash injuries. A plague on all of you.
Get the government OUT of the business of propping up real esate prices NOW!

Aug 29 12:03 PM