Fannie (FNM) and Freddie (FRE) are levered more than 50 to 1 (considering their assets on their book, and about 200 to 1 considering also their off balance sheet guarantees). These are levels that would make a Peloton or Bear Stearns portfolio manager blush.
Consider their precarious situation:
- They have had a substantial decline in collateral value (house prices) of perhaps well over 10 percent or so, and with an expected further decline of another 10 percent or so (Case-Schiller index figures are higher than these and OFHEO index figures are lower).
- They have growing default rates and the economy is going through what may be a long and deep recession, most likely the most serious since the 70s, and possibly since the great depression of the 1930s.
- They have significant exposure to sub-prime and ALT-A (actually several times their equity capital)
- "Conforming" mortgages were also affected by the lax and fraudulent practices in the mortgage market, so their quality is not as good in the later vintages as it used to be.
- The mortgage insurers they were relying on to cover first losses were recently downgraded and most likely will not be able to meet the their obligations on all upcoming claims; they are going out of business and will probably become insolvent.
- Management, particularly FNM’s, has been in a state of denial.
- Accounting and controls at the firm are still weak. Management seems to be still tempted to window dress; e.g. they've recently changed the way they calculate their loss ratios which makes them look better, and stopped buying the portfolios of defaulted mortgages for which they provided guarantees to avoid recognizing losses upfront; they now provide the guarantee payments to the holders of the MBS on an as-needed, ongoing basis, and they have not written down their investments in equity in affordable housing tax credits, which the company can only take advantage of if it has profits
The compounded affect of all these adverse elements, particularly the increase in default rates coupled with falling collateral and the weakness in the mortgage insurers, leads to an exponential, not linear, increase in losses for the agencies.
So the equity market value of the housing agencies, Fannie Mae and Freddie Mac, continues to get smoked, with a 15%+ drop yesterday. I fully expect, with over 90 percent confidence, that FNM and FRE shares will end up virtually worthless in the coming few months (they are no more than a deep out-of-the-money call option).
Given that these entities, with a current combined equity market value of about $25 billion, are supporting a book of mortgages of about $1.5 trillion and over $4 trillion of guarantees (so with ratios of equity to assets of 1.5 percent or 0.5 percent, respectively), it follows that they will have to raise substantial amounts of equity to rebuild their capital bases, perhaps as much as $50 billion each, possibly more.
Now who would be willing and able to invest such large amounts at this stage? The New Jersey investments division?...
The answer is no one - except the US tax payer. I suggest that rather than trying to throw sand in the eyes of the public and come up with a more aesthetic solution, the government should just look at an outright nationalization. The agencies experiment did not work; let's call the whole thing off. Equity holders should be wiped off, and perhaps debt holders should take a very modest hair cut (say 5-10 percent of principal).
This solution would presumably allow a full recapitalization of the agencies, an improvement in their ability to do business and contribute to avoiding an overshooting on the downside of the decline in housing prices. It would also allow the government and the tax payers to fully participate in any upside of the agencies' business. To paraphrase Dave Einhorn : “No more private profits and socialized risks”.
Disclosure: Author holds short position in both FRE and FNM
