The Case for Wiping Out Fannie and Freddie Shareholders

Peter Wallison at AEI has a missive out applauding the government's move in supporting Freddie/Fannie, but scolding them for fuzziness about their equity purchase plans. If/when they decide to purchase shares, they need to wipe out Freddie/Fannie shareholders -- or risk bigger losses down the road.

Here is Peter:

The Treasury’s formal recognition of the government’s responsibility for Fannie Mae and Freddie Mac is an important and essential step forward. No other position was possible in current conditions. The market reaction shows that Treasury secretary Henry Paulson’s statement had the desired effect: the market is now convinced that the U.S. government stands behind Fannie and Freddie.

The proposal to purchase an equity position in either Fannie or Freddie, however, would be a mistake unless their existing shareholders are wiped out and the government takes full control of their management. Allowing the continued operation of the companies as private, shareholder-owned institutions, while the taxpayers are ultimately responsible for their losses, recapitulates our experience with the savings and loans less than twenty years ago. In that case, forbearance in closing them down when they were insolvent, or nearly so, allowed them to “gamble for resurrection,” ultimately increasing the losses that the taxpayers were required to shoulder. The same result can be expected if Fannie and Freddie are allowed to operate indefinitely with government capitalization. Regulation alone has never been able to prevent this risk-taking.

The same problem is present when and if the government lends to Fannie Mae and Freddie Mac without assuming control of their operations. Again, government support allows them to continue taking risks, which will only increase the losses when the taxpayers ultimately have to meet their obligations and close them down. Nevertheless, a substantial line of credit for Fannie and Freddie at the Treasury would be necessary to meet their obligations as they come due, while their operations are reformed or wound down. Their assets cannot be sold in amounts necessary to meet these obligations without putting further downward pressure on already stressed housing and mortgage markets.

Finally, the proposal to open the Fed’s discount window to Fannie and Freddie makes no sense at all unless they cannot raise funds in the credit markets. The capital markets have always believed that Fannie and Freddie were backed by the U.S. government, and the recent moves by Treasury confirm the validity of that view. In that case, both government-sponsored enterprises should be able to raise funds in the credit markets at lower rates and in larger amounts than they could borrow from the Federal Reserve, and without collateral. If the credit markets are now unwilling to lend freely to Fannie and Freddie, however, there is no choice but to enact legislation that will enable them to be taken over by a receiver. Borrowing from the Fed can only be an interim step in that direction.

 

Comments

[John Stiles:]

It seems to me that Peter's comments miss on several points as follows: 1) Fannie's and Freddie's shareholders have already suffered significant loss with the stocks of each having declined better than 80% since last Fall. Does taking away the last few dollars of value teach them a lesson?, 2) Some of the losses that Fannie and Freddie have endured have come at least indirectly from US Gov't (both the executive and legislative branches) encouraging them to continue to support the housing/mortgage market during the past 12 months rather than adopting a more conservative stance that a business free of government influence might have moved to. Does the government not bear some responsibility for these losses? 3) If the government wipes out the shareholders now, who will buy newly issued shares when the powers that be in Washington and New York want a to recreate the 2 firms as stockholder owned entities? 4) Does anyone outsider of the beltway really want a government operated/controlled entity to become the primary holder/packager/re-sel... of home mortgages or believe they can do a better job?

Where are the calls for investigating whether some of the large hedge funds and brokerages have engaged in naked short selling of Fannie's and Freddie's stock. Volume over the past 3 trading days exceeds both firms' outstanding shares.

2008 Jul 14 04:57 PM

[Malkiel:]

Oh PULEEZ! Stop with all the righteous posturing about "moral hazard" in its various forms. Does anybody think the US government is going to allow Boeing or Northrup to go down the tubes if they supply all our military jets? Does anybody think Uncle Sam is going to allow GM and Ford to die at the same time if it means we don't have a domestically controlled auto manufacturer? And does anyone think vested interests are going to allow government to scare off all investors by allowing their existing shareholders to be decapitated when the bailout comes? Capitalism doesn't exist in a free market, it is always a partnership of government and vested interests. You can believe in capitalism or you can believe in free markets, but you can't believe in both and still be considered a savvy or honest observer...

2008 Jul 14 05:07 PM

[icandoitdon:]

good grief....you guys must own the stock.

these organizations should not be public entities and wards of the state at the same time. why, you ask? because they enjoy favored status in the marketplace and they will trade off that for their own benefit...not for the benefit of their benefactor and lifeline, which is the taxpayer. this is exactly the history of these agencies and you guys seem oblivious to it.

if these outfits need capital and can't get it in the public marketplace and have to turn to the government for it the least shareowners should expect in return for their survival is substantial dilution. that i think that's exactly what they're going to get when all the dust settles.

2008 Jul 14 05:55 PM

[TKTK53:]

My only comment is Paul did you read your article before you pushed PUBLISH DON'T THINK SO
Where do you come up with these wild ideas
TKSK

2008 Jul 14 06:15 PM

[TKTK53:]

THIS IS FOR ALPHA
When are you going to put our current postings one the top instead of the bottom???????
TKSK

2008 Jul 14 06:17 PM

[rigel:]

Waverly, given the volume on Fannie's stock recently, only truly stubborn investors lost 80% of their wealth. Instead, bottom fishers came in a various (wrong) points. So do *you* believe that the bottom fishers should be rewarded by a government bailout that doesn't wipe out their equity? Taking away the last few dollars does teach them a lesson: don't expect privatization of profit and socialization of loss.

2008 Jul 14 07:19 PM

[borisb:]

The housing bill will buy forclosures
in the 3rd quarter and this may damped the pressure on 3rd quarter income statement FRE/FNM , which might lessen their need to raise more capital.

2008 Jul 14 07:38 PM

[ksmithdc:]

Borisb - very good point. We should wait to see the effects of the housing bill for Q3.

2008 Jul 14 08:23 PM

[jackson hill:]

Senator Schumer forced Fannie and Freddie buy extra $145 billion in mortgages. But in meantime, his best friends at hedge fund and private equity firm get ready to short FNM and FRE.

www.inman.com/news/200...

New York Times reported that hedge fund managers have a new champion in their effort to keep legally dodging the taxes the rest of us pay: none other than New York Senator Charles Schumer. Now you know who is Schumer's friend and why he caused the bank run on Indymac. He truly support hedge fund and private equity because they truly support him.

www.nytimes.com/2007/0...

"Large Investor decided to pay a few bucks to a Senator in New York to force the issue."(Prospect Mortgage Backed By Sterling Fund--Private Equity Acquired The Mortgage Branches from Indymac before FDIC takeover)
www.housingwire.com/20.../

"And do remember that there are many investment bankers located in New York, making them pretty influential constituents of Sen. Schumer."
www.pasadenastarnews.c...

"In a Sunday news conference, he said everything in his letter was already known to the public."
If it was already known to the public, what is the reason for his public letter? It is contradict to what he said previouly :"I just bring private message to the public. Do not kill the messanger." What a great liar from time to time!
www.cnn.com/2008/POLIT...

2008 Jul 14 08:35 PM

[marinsunshine:]

It would be interesting to see what happens, if the FOMC decided to buy FN and FH stock through several technical resistance points. It would take might take several tens of millions, but they would get a good return by selling if back as the shorts begin to croak. I ordinarily don't advocate this sort of thing, but I think Fannie and Freddie are that important to the fabric of our country.

2008 Jul 14 09:12 PM

[E Nuff Sed:]

Wiping out the share-holders will acheive no purpose since they bought the stock in good faith going by the govt rules (OFHEO) on leverage and to date OFHEO says Fannie Mae, Freddie Mac remain 'adequately capitalized'.

The people baying for the current share-holders blood are people on the short stock band-wagon. While a massive dilution "probably in the order of 75%+ may be in order (and congress may have change the rules on capitalization) - I cannot see the shareholders getting totally wiped out.

The housing market will stablize in less than a year and then a slow climb out of the hole will begin.

Any yes, I am one of the "bottom feeders" and I don't deserve to be wiped out.

2008 Jul 14 09:21 PM

[gekko13:]

There are already enough morons running government agencies, and now you want to turn Freddie and Fannie over to them too? Government will always have a 9 to 1 CR (cretin ratio) because government deserves it. They pay paltry wages, promotion is usually tied directly to service time instead of ability, and due to minority favoritism and cronyism, the best person for the job usually doesn't GET the job. Why would anyone with any real talent or intelligence want to work for the government when they can do better financially in a much shorter time in the private sector? And I am speaking from experience. One year in the Social Security Administration is all it took for me to pack my bags.

I had a college degree, had a 98% efficiency rating in my unit, and took about 80 calls a day on average. Then one day, a career crony came up to me in the office and said, "Johnny, why do you work so hard?"

"Well, I'm just doing my job," the inner innocence of a 24 year-old compelled me to say.

"How many calls a day do you take?" he asked.

I replied, "About eighty."

"And HOW MUCH do you make a year?" he continued.

"Twenty-two thousand." (This was circa 1994.)

Crony thought for a moment and then said with a grin, "You have to be like me. I only take twenty-five calls a day and I make forty-five thousand."

I went home that night and thought about my conversation with the crony. It weighed on me for a few days.

One needs to look no further than the pending merger between XM and Sirius Satellite to see cronyism, corruption, and bureaucratic ignorance at its best. And the guilty party is the FCC and congress, who are being paid off by lobbyists who are against the merger. This, after the Department of Justice ruled back in March that the merger was not monopolistic and would benefit consumers. This after the DOJ gave the green light WITHOUT the companies having to give concessions. The proposed merger is a mouse compared to other mergers in history, with the combined market cap of the companies hovering near 5.6 billion dollars. Yet it is the longest running merger proposal in history, surpassing 400 days! Meanwhile, Exxon and Mobil, two oil behemoths were allowed to merge relatively smoothly, considering the monopolistic concerns involved in that one. (How do you like gas prices today?) And now Anheiser Busch is going to be gobbled up by a foreign entity in three shakes of a lamb's tail. The actions, or rather, INACTIONS by the FCC concerning XM/Sirius wreak of BLATANT POLITICAL CORRUPTION. And you want Freddie and Fannie to be run by the same filth? And people wonder why our country is so screwed up?

By the way, ten days after my conversation with Crony on the office floor of the Social Security Administration, I gave my boss my two-week notice.

2008 Jul 14 09:59 PM

[icandoitdon:]

"Any yes, I am one of the "bottom feeders" and I don't deserve to be wiped out."

with all due respect, the stock market doesn't assure a return of capital. you might want to consider insured CDs. you won't get wiped out there.

2008 Jul 14 10:16 PM

[E Nuff Sed:]

I guess that wann't a smart thing to say - I may not deserve to but I can get wiped out. I can afford a loss having made more than my share of money in the last few years.

- but seriously, I cannot see share-holders getting wiped out. With the Fed discount window open, the GSE's have "unlimited liquidity" at least for the short term. The risk is dilution by the Obama's treasury - inspite of that I see the stock back in the 50's in 5 years - A five to ten bagger - worth the risk.

2008 Jul 14 11:24 PM

[icandoitdon:]

i've said a few not so smart things too as many posters would attest i'm sure.

here is the problem in my view:

i believe that the housing market and economy will likely get worse..possibly much worse. what's happened to the financial stocks is a microcosm of the structural probems in out economy. too much cheap credit and too much leverage. it is a snowball rolling downhill and the fed cannot stop it...god knows they've tried.

if this comes to pass, there is no way FNM and FRE will be able to raise equity capital from outside sources. we know that FNM and FRE say they don't need more capital. do you believe them? i don't because the financial graveyards are full of firms that went to their death denying they were sick...bear stearns being the last. or how about ABK and MBI? these managements cannot be trusted. the market says they do and i'll believe the market every time before i believe management.

with sources of outside capital cut off, that leaves the fed's...the taxpayers...as the equity investor of last resort; and if the future risk capital that permits them to continue operating comes from taxpayers the rewards must also accrue to the taxpayers. that's how it should work and that's how it will work. there is no way they can or will share the future spoils with the very mangement that drove them into the ground.

the only way i would invest in these companies is if i believe the housing market has bottomed and the economy is likely to improve quickly from here. neither is true. if you do invest, set stop loss limits. hedging with puts is too costly.


i think they will. the government won't just step in and support the common. even if they keep management in place they will want the profits in exchange for the requisite capital infusion. it just doesn't make sense to bail out shareowners if it comes to that.

2008 Jul 15 01:42 AM