Fannie & Freddie: Truth or Consequences (Part 2)

See part I here.

Running Out of Options

With the recent collapse in share price, both GSEs are going to have a very difficult time raising capital. You won’t find many buyers of the stock after its recent dive. And issuing debt doesn’t seem to be much of an option. The last thing investors want is to buy debt from companies involved in the mortgage mess. Even if they could find buyers, they would be forced to issue a very high coupon, which would add another drag on cash flows.

For Fannie (FNM) and Freddie (FRE) to have any chance at all to raise additional capital, it’s likely they’ll have to issue some type of convertible preferred stock, with very attractive features (warrants, enhanced voting rights, very attractive conversion rate, etc.)

The Truth Won’t Always Set You Free

All of this aside, we need to remember there’s no real evidence that either GSE is flirting with insolvency. However, we cannot ignore the market sentiment. We must keep in mind that market perception can create a self-fulfilling prophecy. I have seen market panic or even rumors destroy companies many times in the past. The stock gets beaten down, and then rating agencies downgrade the debt, causing higher interest payments to be made due to the increased risk. Finally, the company cannot raise capital since the stock is so low. If the stock remains low over an extended period, rating agencies sometimes downgrade the company and its outstanding debt. Sometimes debt covenants are triggered, forcing immediate payment of debt. There are numerous possibilities.

The point is that it is never a good situation – unless you had a short position, which points to incentives to create solvency rumors. The bottom line is that even when a company is fundamentally solid, a collapse to a very low share price can lead to its demise if it remains low.

Consequences of Failing

The consequences of Fannie and Freddie becoming insolvent are huge. For 2008, consensus estimates expect 2.5 million foreclosures. The real estate correction is far from hitting a trough, but it threatens to mount a slow recovery for several reasons.

• Inventories are still much too high
• The number of actively searching home buyers is too low

Why might this be? Well, inventories are too high because builders are even more clueless about what is going on than Washington. These are individuals who analyze the market by focusing on comparables and monitoring inventories. What they are missing is an understanding of the true nature of the economy and credit crisis.

Perhaps if Washington hadn’t fudged the data, builders could respond to the recession in a timely manner and inventories wouldn’t be so high. The next variable is the lending institutions. Throughout this fallout in real estate, the Fed has been trying to stimulate banks to provide as many loans as possible, with of course a focus on prudent loan qualifications. But most of the banks are approving only those with the highest credit ratings.

What all of this means are fewer loan originations for Fannie and Freddie, or to be blunt, lower cash flows. And at the current foreclosure rate, it is likely the GSEs will be paying out huge claims for the mortgage debt they guaranteed. In my opinion, without additional capital Fannie and Freddie won’t make it. With 70% of all new mortgages involving Fannie or Freddie in some way, failure of one or both would create a big problem that would spread throughout the globe. Thus there is no way Washington would allow them to collapse.

I continue with more excerpts:

I want you to stop and think for a minute about all of the fraudulent practices within the housing industry. From inflated appraisals alone, 10 to 15 percent of MBS securities or up to $1.5 trillion have been overvalued. Combine that with the lack of transparency, questionable risk exposure and fraudulent practices by executives at Fannie and Freddie, and you have a disaster ready to strike. Now combine that with over 10 million Americans holding interest-only and ARM mortgages, throw in a million or two job losses due to say the failure of Delta, Ford, General Motors, or some other large vulnerable company, and you could end up with a blowup in the MBS market. This scenario would devastate the stock, bond and real estate markets. Most likely, there would also be an even bigger mess in the swaps and derivatives markets.

Under normal conditions, anywhere from 25 to 30 percent of the U.S. economy is directly affected by the housing sector. However, due to exaggerated asset prices from the housing bubble, this share is significantly higher. Housing prices have up to two times the effect on consumer spending as they do on declines in stock prices. Consequently, if housing prices decline by 25 percent, the economic impact will be as if the stock market declined by 50 percent.

Housing prices are absolutely critical to the success of companies such as Lowe’s, Home Depot, and Sears. As well, most banks are closely tied to the health of the housing market because one way or another you can bet they have exposure to the MBS market. Many of the larger financial institutions have a much greater risk exposure with real estate derivative products. Most likely, it will take several years for the real estate washout to be completed. We can only hope that the MBS market doesn’t experience its first blow up since inception, but don’t bet on it.” (Source: America’s Financial Apocalypse: How to Profit from the Next Great Depression)

As you might suspect, the current problems faced by Fannie and Freddie aren’t surprising to me. If they aren’t able to raise adequate capital they’ll need a bailout or a buyout. Bankruptcy is not an option (unless you count a court-appointed conservatorship by the government, which would wipe out shareholders).

No matter what you want to call it, the effects will be the same – more pain to the financial industry and the dollar. But it won’t send with Indy (IMB), Fannie, Freddie or the rest of the financial industry. Most likely the automotive and airlines industries will also need a bailout – that is, unless some firm is foolish enough to buy them. Sure, Cerberus bought Chrysler, but at fire sale prices, and prior to the current meltdown. In conclusion, based upon the continued washout taking place in the mortgage and banking industries, you would be advised to buy gold, oil, and foreign currencies. And of course, keep a good deal of cash and just be patient.

As investors, you should consider the possibilities I have mentioned. Take a look at your portfolio. Is it positioned to take advantage of or avert the effects of America’s financial apocalypse? As consumers, you had better start thinking about any cash you might have in some of those high-yield savings and money market accounts. Understand that some money market accounts have invested in CDOs and other junk linked to mortgage debt. Also understand that your bank could be the next IndyMac.