Fannie & Freddie: Truth or Consequences (Part 1)

Amidst speculation that Freddie (FRE) and its big brother Fannie (FNM) are facing insolvency, U.S. Treasury Saecretary Paulson said the primary focus was supporting Fannie and Freddie "in their current form as they carry out their important mission."

Well, the fact of the matter is that “carrying out their mission” is what got them into this mess to begin with. Paulson delivered the subtle message that has been interpreted by most that he won’t bail the GSEs out. But if the GSEs aren’t able to raise sufficient capital, it’s going to initiate a printing frenzy by Bernanke, with or without a conservatorship. Before we consider exactly what Paulson’s statement means, have a look at the following excerpts I put into print in 2006.

The original intended purpose of the GSEs was to focus on affordable housing for the private sector. Yet, dozens of studies have shown that Freddie and Fannie have not been dedicating their resources towards this mission, but have been supplying funds to the overall market. Therefore, the GSEs have been a significant stimulus for the rapid growth of sub-prime loan market that has contributed to the enormous risks we see within the real estate bubble. Because Fannie and Freddie lack sufficient government oversight, they haven’t maintained adequate capital reserves needed to safeguard the security of payments to investors. And due to exemption from the SEC Act of 1933, they aren’t required to reveal their financial position.

In fact, they’re the only publicly traded companies in the Fortune 500 exempt from routine SEC disclosures required for adequate transparency and investor accountability. As a result, many feel the GSEs are exposing themselves to excessive risk. Recent investigations have forced Fannie to restate earnings to the tune of nearly $11 billion from 1998 to mid-2004. The SEC has fined them $400 million and the management is now being investigated by the Department of Justice. Thus far, Fannie Mae was found to have misrepresented its risk position, acted irresponsibly, and manipulated earnings so company executives would receive huge bonuses. (Source: America’s Financial Apocalypse: How to Profit from the Next Great Depression)

Is this the “important mission” of the GSEs Paulson was referring to - fraud, mismanagement, excessive risk, and abuse by management of a quasi-government agency?

Reading between the Lines

While Paulson has hinted that there will be no government bailout for Freddie and Fannie, he clearly left the door open to intervention.

"It is clear that some institutions, if they fail, can have a systemic impact." However, financial players need to be disciplined in managing risk and not expect the government to fly to their rescue, he added. "For market discipline to effectively constrain risk, financial institutions must be allowed to fail," he said.

Let’s take a look at the implications of what he has said. First you need to understand that a “bailout” can be interpreted in many different ways. Formally speaking, a bailout of Freddie and Fannie would entail the government going in and capitalizing these firms by however much was needed to maintain their solvency.

This could be done by one of two ways. Either a carte blanche of funds supplied by the Fed, or by a government-appointed conservatorship (an individual appointed to manage the company according to specific guidelines using federal funds). Under that later scenario, shareholders would most likely lose everything because the companies would be removed from the public exchanges and run in a manner similar to bankruptcy.

Importance of the GSEs

Fannie and Freddie serve as the engine of liquidity for the entire mortgage industry. They issue mortgages to raise cash, then repackage mortgage debt into a variety of tradable securities and sell them off to institutions. With the cash they generate from selling these securities, they pump more money into the mortgage market for new loan originations. But they also keep certain mortgage securities (theoretically the highest credit ones) known as its retained portfolio to generate (would be) steady and predictable income to fund certain operations.

In addition, much of the debt sold to institutions is guaranteed by Fannie and Freddie, making them similar to the monolines like MBIA and Ambac. Combined, they hold around $1.4 trillion in their retained portfolios and they’ve guaranteed over $3 trillion of what could end up being junk bonds. So you can think of Fannie and Freddie as a hybrid of bond insurers like MBIA and AMBAC, along with Washington Mutual and Countrywide.

Fundamentally Strong or Dangerously Vulnerable?

Since the GSEs are not well capitalized, they could face insolvency as foreclosures increase. But several Washington officials have insisted both are strong and have adequate capital.

From "Fannie, Freddie say they have plenty of capital":

"These institutions are fundamentally sound and strong," Dodd said at a news conference. "There is no reason for the kind of (stock market) reaction we're getting."

When you’re undercapitalized and have over $4.4 trillion in debt and guarantees on your books in the midst of the biggest real estate meltdown in history, and when management has recently committed accounting fraud, I don’t see fundamental strength. Furthermore, when you are part of a banking system that’s already recorded $400 billion in write downs, with much more to come, and has borrowed $1.2 trillion from the Fed just to remain solvent (with much more to come) – when you’ve been forced to issue billions of dollars in new stock and debt - this banking system, of which Fannie and Freddie are closely linked – is far from being strong.

From "Paulson: No Bailout for Fannie Mae, Freddie Mac": 

"Although there is some danger here that Fannie and Freddie may become insolvent, I think it's very, very remote unless for some reason the credit markets lose confidence in the willingness of the U.S. government to stand behind them,'' said Peter Wallison, former general counsel at the U.S. Treasury told Bloomberg Radio. "It's impossible to imagine such a thing happening.''

I recall just a few months ago “experts” claiming the U.S. economy was “impossible” to stop, or that the real estate crisis was “turning around in November 2007,” as well as similar statements being plastered throughout the media by “experts” virtually every month in 2008. Even as late as June 2008, “experts” were boasting over our “resilient economy. Everything is “great” they claimed. “GDP, while not as high as we anticipated, is still respectable, unemployment is low,” etc. Check the archives from all of the television news and financial shows as well as the print media and you will see what I mean.

Senator Dodd is clearly trying to restore market confidence. Mr. Wallison is either trying to restore confidence or else has no idea what the credit default swaps market is saying. Most likely, he is taking the role of cheerleader similar to Dodd. That is precisely why they were interviewed. It’s been a theme of denial by the pundits and government officials – the guys who have the strongest ties to the media. A denial since August 2007, when it was obvious what was in store for the real estate market.

We should not be forgiving of investment professionals and pundits who missed the obvious. These are the individuals the investment community relies on for accurate guidance and insight. And they failed you. They missed everything, so you shouldn’t rely on anything they say going forward. Their agendas will always be different from yours.