Saving Fannie and Freddie

The WSJ's front page this morning features an important-sounding 1,500-word article on contingency plans for Fannie Mae (FNM) and Freddie Mac (FRE), recapitulating Katie Benner's article in Fortune yesterday. What would the government do if the companies ran into trouble? What could it do? We learn that people in the Bush administration have been asking such questions, which is prudent and sensible. But we don't learn what kind of answers they might be leaning towards.

What, exactly, is the problem? Well, as William Poole is keen to point out, if Fannie and Freddie were forced to liquidate their assets tomorrow, they couldn't raise enough money to pay off their liabilities.

Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.

Mish is on a similar track:

Fannie Mae holds or guarantees over $5 trillion in mortgages. A mere 1% decline would wipe them out. Is that adequately capitalized? I do not think so.

This is maybe less scary than it seems, since there's no chance that either entity is going to be entering a forced liquidation of anything. And one look at General Motors (GM) is enough to show that a company with negative net worth can continue as a going concern more or less indefinitely, even without taxpayer support. Or, to put it another way, being "wiped out", in Mish's terms, is interesting from an accounting point of view but doesn't automatically trigger the need for drastic actions like nationalization or multi-billion-dollar government loans.

What's more scary is the share-price dynamics. It makes sense that the share prices of these companies have fallen as investors anticipate large and dilutive new equity offerings. But the problem is that the further the share prices fall in advance of the new issues, the more dilutive those issues are going to be. And at some point those issues become effectively impossible:

Egan estimates that Freddie alone will need to raise $7 billion over the next two quarters due to writedowns and losses. But the company's market capitalization stands at $8.7 billion.

 

"An investment banker would be hard pressed to raise an amount of money nearly equal to the value of the entire company," Egan says.

On the other hand, the GSEs do still seem to be able to be able to issue a large amount of debt. Issuing 30-year bonds would be much cheaper than issuing equity, and would serve much the same purpose, if regulators were happy to treat the proceeds as equity, at least for, say, the next decade.

My gut feeling is that the government is being prudent, war-gaming worst-case scenarios in terms of fiscal policy just like it does in terms of foreign policy. Ultimately it's conceivable that Fannie and Freddie might need to be nationalized, which in a way would only make sense since no one ever believed that they were really private companies in the first place. At that point they would stop having to mark their assets to market, and might well never lose money on a cashflow basis. But the effect on the total US national debt would be extremely unpleasant, and I'm sure that no one in any administration would want to go down that route except as a very last resort.

Comments

[bbzz24:]

Salmon is right here that as long as cash inflows from mortgage payments are greater than coupon outflows the companies will stay afloat. All their assets are hold-to-maturity and the ongoing depreciation is not a concern now but may be in the future when the pricipal has to be repaid.
But from investor's perspective is a 50:1 leveraged company a prudent investment? Certainly not when it's assets are deflating.

2008 Jul 10 09:35 AM

[Research123:]

Wall Street has been trying to kill Fannie and Freddie for years. If they succeed, it will ultiamtly lead to a fragmented and expenseive mortage market with no central well understood set of rules, since the notion of "conforming loans" will dissapear without financial heavyweights to enforce the rules.

Make no mistake, a Wall Street victory in the name of free enterprise will spell the death nell for the form of widespread mortage-fuled homeownership that has lifted vast swaths of America up into the middle class over the past 80 years.

Congratulations, financial economists!

2008 Jul 10 09:57 AM

[Blue Chip S...:]

In the words of my boss: "If you believe in Goldilocks, then you have to believe in The Three Bears."

2008 Jul 10 10:33 AM

[ferguson:]

In light of the Bush administration record on foreign policy, the reasurrance that the government is only "war gaming" the Fannie Mae, Freddie Mac situation "just as it does in foreign policy" is not the least bit reassuring. It is, in fact, frightening.

2008 Jul 10 11:08 AM

[Blue Chip S...:]

Due to the peculiarities of securitization, The future cash flow from a lot of their assets is impaired. Practically all of the finance companies and banks that have (over)utilized securitization over the past decade have juiced-up their earnings and frontloaded their gains on the underlying assets at the time that the securitization was transacted. For instance; a par value mortgage (at 100) was "sold" through securitization at 103. The 3% premium is a PV of the future expected cash flow under "normal" conditions. The 3% is received as cash from the investors in the ABS bonds and is booked to P&L and thus Equity at the time of issuance. All the issuers of ABS were juiced by this drug and since the supply (market liquidity and new originations) has dried up they are suffering from withdrawal which absent emergency medical treatment may cause death.

2008 Jul 10 11:19 AM

[Lex Luz:]

Given that shadow Bush advisor Grover Norquist has repeatedly called for the United States Government to accelerate the growth of the national debt past the point of insolvency in order to force a government "so small you could drown it in a bathtub," he's probably among the biggest proponents of nationalizing Fannie & Freddie immediately.

Make no mistake: the people in office today are traitors and fascists, advised by traitors and fascists. Absolutely every sitting member of the executive and legislative branches, and the majority of the judiciary, is complicit in the willful, planned destruction of this nation. Most members of the so-called "liberal media" are complicit in the quiet fascist takeover of the United States as well.

I believe that by the end of 2012 there will be blood in America's streets. What we're seeing today is just the very beginning of the planned unraveling of this nation, and all of us who have voted for Republicans (especially) or Democrats (no better) over the past 28 years have participated quite fully in it.

2008 Jul 10 11:23 AM

[Edward Janeck:]

Greenspan said it took him long time to understand Fannie derivative book. Fortune say these companies could cause a trillion dollar bail out from tax payers. They were over-leveraged, nobody understood their derivatives, and they didn't file financial statements for 2 years. You could see it coming.

2008 Jul 10 12:13 PM

[Jason Rines...:]

Lex Luz: Correct on advising to the Bush Admin. The Bush Admin was pushing for North American Union which was way ahead of it's time (along with attempted new world order) so he was easily manipulated by fascists with there own agendas. The President was definately misled and his own ambitions allowed him to be blinded to ulterior motives. But some of us started reaching out months ago and he gets it now.

In regards to this article, you let Fannie and Freddie downsize and solve it's own problems. No more funding. It may fail along with the irresponsible shadow banking system dragging us all down with it. To restore our national directives, I prefer getting it over with then muddling along for ten years in pain and indecision while we continue transferring our wealth to aggressive nations which no doubt will use such resources to further destabalize us.

Right now we still have plentry of resources to rebuild but NOT if we socialize the nation and continue draining the responsible citizenship for hair-brained schemes where the top 1% of NYC and Washington continued to act as parasites and drain the nation of brains and resources. Let the forest burn down a bit to reseed, not keep attempting to save the dry rotten trees.

2008 Jul 10 02:36 PM

[SeekingBottoms:]

The Federal Reserve is neither fedaral nor holds reserves: it is a cabal of PRIVATE bankers who are in the business of loaning money. They have used Fannie and Freddie as a conduit to pump the US economy with oceans of cash...upon which they collect interest as bankers are wont to do.

The FED, I posit, is not the SOLUTION to our economic malaise but rather the SOURCE of it. THe Federal Reserve MUST be abolished before it finishes the job of taking over the United States entirely.

2008 Jul 10 09:02 PM