Fannie and Freddie: Not Worthless Yet 18 comments
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On Monday, the respected financial services boutique brokerage firm, KBW, published a report declaring the common and preferred shares of Fannie Mae (FNM) and Freddie Mac (FRE) to be "worthless." The conclusion of the report was based on a contrived scenario where Fannie and Freddie are separated into good-bank/bad-bank entities and the future profits are diverted away from paying down the government's ownership stake in the companies. If this scenario were to happen, it would be another huge subsidy for the big mortgage banking firms at the expense of taxpayers like you and me.
Bank Co-operative Model is a Bad Idea
Fannie and Freddie should not be restructured into bank-owned co-operatives. The brokerage report held up the FHLB System as a model for the future structure of Fannie and Freddie. The FHLB System is a poorly constructed system and is not an enviable model. The FHLB System allows the large banks to borrow money at government subsidized rates. The banks can use this borrowed money for any kind of lending they want such as auto loans, commercial loans, boat loans or even loans to foreign countries.
This system has not prevented the FHLB Banks from posting large losses during the housing crisis. Another reason the FHLB System is bad is that it presents sizable systemic risks because it has no permanent capital. Members of the FHLB system can withdraw their capital on 90 days notice. In spite of nominally higher capital levels, the fact that FHLB capital is withdrawable makes the banks less stable than Fannie and Freddie. Moving Fannie and Freddie to a less stable capital structure is a bad idea.
Good-Bank/Bad-Bank Proposal Doesn't Make Sense
Separating Fannie and Freddie into a good-bank/bad-bank as the KBW authors propose will not work because it is not a classic good-bank/bad-bank restructuring. First, in this proposal, the bad bank can't support itself. Second, the authors transfer ownership of the good-bank to new owners. The concept of a good-bank/bad-bank split only makes sense if both entities are viable and self-supporting and have identical owners.
The good-bank is a clean entity and can be more easily valued by the stock market. The bad-bank is capitalized to be self-standing and management can workout problem assets over time to realize maximum value without worrying about the timing of accounting gains or losses. The classic practical application was Mellon Bank in the 1980's. In this report, the authors propose setting up the bad-bank as a non-viable entity from the start, and they assume a transfer ownership of the good-bank without any compensation. I submit that you can claim any financial institution in the country is worthless under the authors’ version of a good-bank/bad-bank scenario.
Holes in the KBW/GSE Model
There are multiple problems with KBW’s model that shows Fannie and Freddie having problems paying back the Treasury.
1. Bad-Bank Focus– As discussed earlier, as long as Fannie and Freddie are not separated into good-bank/bad-bank entities, they will be able to use revenue from new business to payoff the Treasury’s ownership position. Using the revenue from the good-bank will add $38 billion to Fannie and $25 billion to Freddie.
2. Double Counting Operating Expense – KBW’s model has operating expenses double counted. This adds $14 billion in expense to Fannie and $10 billion in expense to Freddie.
3. Severity Assumption is Too High – KBW uses 60% severity in its base case compared to John Hempton’s severity assumption of 45%. (By the way, the definitive analysis of the current value of Fannie and Freddie can be found in John Hempton’s series of blog postings on Fannie and Freddie.) I trust Hempton’s assumption more than KBW’s as he builds it up by vintage year. This accounts for $29 billion at Fannie and $15 billion at Freddie.
4. Mortgage portfolio run-off is much greater than mandated by Treasury – KBW assumes a run-off of the current on-balance sheet mortgage portfolio at a rate faster than mandated by the Treasury agreement. This accounts for $18 billion in lost revenue at both companies.
With these changes to KBW’s model, I calculate both companies can payback the Treasury:
($ billions)
Assumed shortfall from KBW model -49 -39
With any model, the results are heavily dependent on assumptions. The user of a model must be well-versed in the assumptions before relying on its output. This analysis shows that by changing (and/or correcting) a few assumptions in the KBW/GSE model that the companies have plenty extra capital to pay back the Treasury, which is the opposite conclusion of the KBW report.
Another important assumption in the KBW model, which makes the GSEs’ capital positions look weaker is the assumption that they cannot raise capital from the public markets. Once the GSEs return to profitability, they may be able to raise equity to repay the Treasury.
Conclusion
The GSEs aren’t worthless until Congress restructures them and shareholders no longer have valid claims. Until Congress passes a law, the GSEs are working hard to mitigate their problem loans and to provide continued credit support to the housing market. Their income statements will flip from posting losses to reporting positive net income as we pass the peak loss years on the mortgages of 2006-2008. Freddie reported a profit in the last quarter, and it will be difficult to wipeout Fannie and Freddie shareholders once they return to sustained profitability.
Disclosure: Long FNM & FRE preferred; no position FNM & FRE common
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This article has 18 comments:
The constant attack on the governmnet intervention is an attack on the governments obligation to protect its people. It is an attack on the basic realizations of the American promise of a necessary & fundamental "ownership" and another example of blind market raging and ranting while it takes everything down for profit regardless of the cost. Price cannot be evaluated without reference to cost. These greed giants would well advised to realize that the home mortgage security of these institutions represent a serious fire wall between the very desparately angry populous and their own greedy pursuit of pure wealth and financial power. History is replete with violent turnovers that have backlashed against such constrictions of market wealth. Some grandscale version of this same model was instrumental in bringing about the powder kegs that led to WW1. It is the height of folly to believe that America will allow its homes to be invaded by some priviledged bankers waving banners of free market ideology while they short sell and undermine the biggest investment of these people's lives.. It would be wise to look at the long term prospects. Let the open market work and let the mortgage markets raise its capital through the markets rather than through the tax system and the markets will come through with a balanced resolution.
The best scenario for America would be if the American shareholders could be allowed to invest securely into these institutions and the capital foundation could expand normally the way the stock market was envisioned to work. The "free and open market needs to be protected from these disease ridden parasites hat brought us to this crisis in the first place. A great deal of the taxpayers' burden would be eliminated if the capital could be raised on the market; again, the way it is supposed to work. Instead, we get nothing but the professional predator and parasites eating away at potentially healthy investments and a negative media coverage which tilts the game plan in that direction. The more exagerated the claims the more downward pressure upon the trading and with it any chance of a market based recovery. At this time these stocks should be trading for healing purposes, not to create more victims. Stocks are certainly rock bottom and affordable to the average American. Why not let it work instead of eviscerating the market
Speculating is fine, you'd have better luck in Vegas playing black jack, but after the next wave of Option ARMS coming to maturity it's going to be obvious the govt will bankrupt the country continuing to prop up the GSE's.
www.youtube.com/watch?...
On Oct 21 12:00 PM gebby wrote:
> republicans and their banker backers targeted fnm and fre for their
> mortgage business and then destroyed it.
Damaged as they are - F&F need every possible encouragement in a free market to recover. More government interplay just seems to delay the recovery and opens more doors for political corruption.
On Oct 21 12:00 PM gebby wrote:
> republicans and their banker backers targeted
> mortgage business and then destroyed it.
I suspect there were some politicians somewhere who in exchange for some sort of favor, allowed individuals to sell their junk paper to FREDDIE and FANNIE, and forced them to take it at full price.
Wow, after watching the TARP fiasco I can almost say I fully agree with their assesment. Still, I can't get myself to buy the stuff. For some reason it feels like stealing from myself.
Favorite saying: Pigs get fed, hogs get slaughtered!
Did KBW pick up shares in FRE & FNM when they fell?
I'm surprised to see no legal action against KBW.
Socialism for the rich, poverty for the middle class and crumbs for the poor. Privatize profit while sheding risk and losses to the public.
These thiefs are NOT abeted by only one party, both are complicant. Obama, Dodd and Reid were the biggest recipients of FNM and FRE political contributions. Have you noticed no one is targeting them for executive wage controls???
the congress is the most corrupt entity in the world, apply the RICO statues! Throw all the bums out!
www.kickthemallout.com...
www.rollingstone.com/p...
www.govtrack.us/congre...
They are too big to be properly managed, and the paper they carry is far away from the ground that secures it.
It isn't that anyone forced them to take bad paper at face value, I would guess, because they wanted to show that excess value. What they tell themselves they can spend is based on it. If they are in D.C., what do they know or care about a house in Alaska? Isn't its value what the local guys say?
Showing excess value to pump up turf appearance is not just a federal government problem. In large cities, it's hard to catch these shenanigans and get a large voting public to understand it well enough to bust it.
In some small towns, they catch a graft-recipient's fancy car purchase straight off. They don't need the IRS to tell them about it.
It takes a sophisticated public and a competitive and conscientious press to take on the nitty-gritty bean-counting of getting honesty in leadership.
Many jurisdictions are profoundly challenged in this regard. It is the reason I don't want stocks relating to water. The water issue affects housing, affordability, and health. Large projects are heavily vulnerable to political corruption.
The liabilities associated with doing water badly are sobering, more rife with pitfalls than energy.
The local stuff affects Freddie and Fannie value. If loads of people from the Southwest move because there is no more water, it will increase the value of property in the places where they go and decrease it where they came from.
I don't know how small pooled resources should be, but one or two corruption leverage points in D.C. is clearly a disaster. If it got busted out in groups of three neighboring states, maybe there could be a degree of bickering/cooperation to keep it more honest.
No Bailouts.
No Free Lunches.
No loan to anyone unless the borrower has 20% and the lender 80% of both their skins in the game.
No swaps, no derivatives, no hocus-pocus cow pie tossing or trading at the expense of the taxpayer.
I'm beginning to wonder why I've been responsible and paid my debts my whole life; it would seem I'm the fool for not defaulting on my debt or using it to speculate then claiming bankruptcy, renting, and going to the emergency room for health care.
On Oct 21 12:00 PM gebby wrote:
> republicans and their banker backers targeted fnm and fre for their
> mortgage business and then destroyed it.
FNM and FRE aren't businesses. They are a hole in ground where stupid taxpayers throw money.
Here is the problem you can't serve two masters. You can't serve the shareholders and serve the public good of homeownership at the same time. One will win - in this case the preceived public good - and one will get killed - in this case the shareholders.