Fannie, Freddie Common Stock Is Now A Call Option

John Hussman had some interesting comments on Fannie Mae's (FNM) last earnings statement in Nervous Bunny.

With regard to Fannie Mae's report, the most interesting figure wasn't the reported $2.3 billion loss, but rather the much larger deterioration in the reported fair value of Fannie's balance sheet. We can observe what's going on by comparing Table 32 of Fannie Mae's Q2 2008 10Q filing with the same table in Fannie Mae's Q1 2008 10Q filing.

As of June 30, 2008, the fair value of Fannie Mae's common equity (that is, the book value available to common shareholders) was -$5.39 billion, compared with a March 31 fair value of -$2.07 billion. What's notable here is that this deterioration (-$3.32 billion) was even larger than the -$2.30 billion loss that Fannie reported to investors, which was itself about four times higher than the loss analysts had estimated. Note that balance sheet losses are excluded from earnings. Financial stocks tend to be reasonably valued when they trade at tangible book value, but simply put, Fannie Mae has no tangible book value. The common stock is now a call option.

Even if we include the fair value of preferred equity, we find that on a fair value basis, Fannie Mae is operating at a gross leverage multiple of 72.7 (total assets comprised primarily of mortgage loans, divided by shareholder equity). In other words, a slight 1.4% deterioration in the value of Fannie's book of assets will wipe out all of the remaining shareholder equity. This makes Long Term Capital Management look like a conservative strategy.

Another Take On Fannie and Freddie Options

Minyanville Professor Bennett Sedacca was also talking about Fannie Mae and Freddie Mac (FRE) options in a A Tale of Two Markets, Part 1.

 

Freddie was supposed to raise $5.5 billion according to its earnings announcement back in June 2008. The problem is that it decided to wait for a better time in the market to raise this capital. However, in the meantime, its common stock price plummeted from $25 at the time of their announcement to a recent $5. While they only have 750 million shares outstanding, issuing 1.5 billion new shares really wasn’t an option as this would dilute the current shareholders beyond recognition.

Now Treasury Secretary Paulsen is cooking up a bailout of Fannie and Freddie, which I imagine will eventually end up as full-fledged nationalization as I have been talking about for some time. After many discussions with informed traders and bankers, the plan that I envision (as revolting as it may sound) goes like this:
...
While I am fairly confident my view will play out, I openly wonder if this model won’t be used for other troubled institutions (like overleveraged financial concerns like Lehman (LEH), Merrill (MER), Citigroup (C) and AIG). They are important to the system as well. The Fed and Treasury know this, of course, and the while many important entities will probably be saved, there may be many others that are too small to care about and so poorly run that no one wants them -- you can throw National City (NCC), Zions (ZION), Regions Financial (RF), KeyCorp (KEY), into this category -- not to mention countless privately controlled community banks.

Fannie Mae Daily Chart

click on chart for sharper image

Freddie Mac Daily Chart

click on chart for sharper image

Financial Intervention

Paulson and the SEC acted to initiate a short squeeze in Fannie Mae, Freddie Mac and financial in general. Please see Panic By The Fed: Anatomy of a Short-Squeeze and Selective Enforcement of Regulation SHO for more details.

The squeeze "worked" until the juice dried up. Fannie rose from $6.68 to $18.48 in one week flat. In two weeks flat it was back at $8.40. Freddie Mac rose from $3.89 to $11.60 only to fall back to $5.43.

Now it appears that the common stock of both is likely to drift towards zero, especially if the situation plays out as describe above by professor Sedacca.

One of the purposes of of Paulson's and the SEC's manipulation was to force the price of Fannie and Freddie up so that new capital can be raised. The above charts show the manipulation failed spectacularly. Yes, some financials held their gains but some like Washington Mutual (WM) did not. Did the squeeze partially work then? The answer is no, not really.

As we have seen many times in the past, every time sentiment gets extremely bearish there is a rally. Sentiment against financials was nearly off the scale a few weeks ago. What Paulson and the SEC did was goose the initial bounce, no more, no less, and it appeared to "work" only because financials were poised to rally anyway. Careful scrutiny will show that financials, like the dollar, rallied because they were damn good and ready to rally.

Sadly, many otherwise extremely bright people make the mistake of equating correlation with causation, time and time again. Sadder still is some of the acrimonious debate over this point.

But the fact of the matter is the dollar was poised to rally. Sentiment was as bearish as I have seen it in spite of the fact that fundamentals on the dollar (expected movements in interest rate differentials, declining oil, and improving balance of trade prospects) were rapidly changing for the better.

So along comes a minuscule (to the forex markets) intervention, and it was supposed to have caused this dollar rally. Sorry folks, it did not cause a damn thing. If the dollar was not poised to rally, intervention would have failed as it did 13 consecutive times before that. Still another chart shows that over $300 billion in currency intervention by Japan did no good.

The key point is that intervention does not work although at times it may appear to work. And this is what leads otherwise bright people to confuse correlation with causation. In the micro-sense, if one is trading very short timeframes, then I suppose from that perspective these manipulations could have meaning. In longer timeframes, attempts to manipulate the market fail every time.

China put curbs on shorting stocks. The Shanghai index fell 52% anyway. The TAF, the TSLF, and the PDCF were all supposed to prevent a collapse like we saw with Bear Stearns. Bear Stearns collapsed anyway.

And I cannot count the number of times in this downturn that people blamed the PPT for propping up homebuilders, or Ambac (ABK) or MBIA (MBI). If the PPT was acting, it sure failed miserably.

Ambac fell to as low as $1.04. So why did Ambac rally? Ambac rallied because pessimism was excessive, Ambac had enough cash to survive for at least a while, and for some, a $1-$3 share price was tantamount to being a rather cheap call option on the possibility it surviced longer. For others, shorts have to cover sometime anyway. Why not start at $1-$3?

So if you think manipulations caused, the rally in Amback (or any other financial) to stick then you are not thinking clearly.

Yes, the Fed, and the SEC, and the Treasury have been openly intervening. Yet, there is no evidence if one looks closely (avoiding the trap of equating correlation with causation), that any of this manipulation caused anything other than a small blip on a screen in a very short timeframe.

Comments

[friend:]

One can bury oneself under graphs and complicated models .

Why not deal with the obvious of limiting the unlawful naked shorting ?

The US economy and the average investor get hurt when stocks oversold by powerful naked shortings .

Why costs would be the stopper in eliminating an unlawful practice ?

The policing of the unlawful naked shorting is long overdue while the unlawful " artists " is taking illegally billions of dollars from the US economy and from the average investors every day .

2008 Aug 12 04:19 PM

[lsully999:]

I grow weary of these articles which tend bash Frannie and Freddie.

Let's assume everything you (and the "Professor") say is true; so what ?!? [Frankly, the article touches so many things - the exact point is somewhat ellusive.]

First of all, to most people who are actually "in the trenches", "fair value" is a meaningless construct - unless you are going to liquidate a company (in which case, fair value would probably over state value). For some reason, "Going Conern" is a concept which somehow seems to have gotten lost in the shuffle.

"Fair Value" might make sense if you are valuing marketable securities; it makes absolutely no sense when attempting to value a 30 year-ish mortgage portfolio in the worst "down" market in 80 years. If you assume the housing inducstry will eventually recover (and if you do not - this is all a meaningless exercise) the "true" value of these portfolios is almost certainly more than the "Fair Value". [And, of course, if you believe that is true, then you purchase those "options" !]

And for the life of me, I simply do not understand why people are so against the Federal Government doing whatever it can to save these institutions; do you really want them to fail, really. [If you do, you lack any credibility.] As near as I can tell, most people appear to be upset that a few executives may have made a little too much money and/or lobbied a little too much on behalf of their company. Talk about throwing the baby out with the bath water ! Good lord; get real.

As a republican, it pains me to say it: but at base line, we really want these companies to behave like utilities; we want them to provide a basic, fundamental service at the best price, further to overall policy objectives and macro-economic constraints. Believe it or not, the recent "bail-out" package put in place certain regulatory oversight which would facilitate such a transition. It's a middle of the road solution which probably makes the most sense. More rational rhetoric will discuss the path upon which we get from here to there.

2008 Aug 12 05:44 PM

[Max Borne:]

I agree with Isully. Well said!

2008 Aug 12 06:26 PM

[A Man:]

I understand that everyone wants to make a profit shorting Fannie, Freddie or other financial stocks. What I don't understand is why some people would like to make a profit with the risk of sinking an entire country. If Fannie and Freddie go under then where would those people who shorted these stocks will spend their money? In Europe, in Asia, in Russia or in Africa? Correct me if I am wrong...

2008 Aug 12 07:40 PM

[madasiwannabe:]

I agree with Isully too. We spend a lot of time looking in the rear view mirror but not out in front of the headlights. In today's stock market, what happened yesterday has no relivence on what's going to happen tomorrow. There's a lot of positive things happening that, if the GSE's survive long enough to realize the benifits, will change their long term outlook.

I haven't seen anyone discuss what's going on over at FHA. With a bump of 300 Billion, they are rewriting ARM's like crazy. Over 75% of the mortgage contracts in July were actually FHA refi's. The majority of these were mortgages were backed by Fannie and Freddie. That means their risk and portfolio size is coming down. Sounds to me like a great compromise that the media is not discussing.

The cascading effects of the GSE's failing are beyond measure. The constant barage of negative press does nothing but hasten thier collapse. Shorts are in a feeding frenzie trying to wipe out what equity remains and as a consequence, the resuling downgrades and rumors of impending failure discourages security investors which in turns significantly erodes their ability to generate revenue. Sounds a lot like a death spiral. Some think the "take out the GSE" party going on is a lot of fun, but there's going to be one heck of a mess to clean up when it's over.

What would be the effect on the economy if the GSE's "high risk" securities were folded into to the government backed securities? Even if not physically folded, wouldn't they be globally associated as such? How will the other 7 Trillion worth of loans not handled by the GSE's be viewed? Wouldn't that lead to a contraction of the financial system and start a cascading banking system collapse? Wouldn't that also accelerate hyper inflation which ultimately leads to economic implosion? Can't expect any U.S. instrument to retain any value after that can we?

This is more complicated than someone using taxpayers money to bail out greedy companies. I would have hoped that the professor would realize this and spend more time figuring out a solution and less time trying to figure out the exact date and time of the GSE's demise.

Forgive us for we know not what we do.

2008 Aug 12 08:03 PM

[icandoitdon:]

" I simply do not understand why people are so against the Federal Government doing whatever it can to save these institutions"

i do. it is not government's role to save any private institution, financial or otherwise. it is the government's role (specifically the fed) to, among other things, ensure that we have a stable financial system. the fed failed miserably in that fundamental, task. arguably, there is none more important and they whiffed it.

failure is as much a part of capitalism as success. it keeps private enterprise honest. government intervention and the ridiculous notion of institutions being "too big to fail" gives the illusion of a safety net that isnt really there. the consequences of such massive mismanagement as we've had in our financial institutions will be borne and felt for years not just by their shareholders but by anyone employed, who owns stocks or has a money market fund. in other words, everyone. when you're paid 2% in a money market account in a 5% world, that 3% is a transfer of wealth from your pocket to the financial institutions that helped engineer the crisis. i personally subsidize these bastards thousand of dollars each year because of their mismangement and i don't like it a bit. neither should you.

i would also point out that the government hasn't "saved" a damn thing by their actions. they've bought time, paid for by you and me. if these institutions can recapitalize with more than a little help from the taxpayer, some will survive. some will fail anyway, including phony and fraudie (credit to whomever coined the phrase). i would argue that it would be cheaper in many ways to let the overleveraged, under-capitalized financial institutions complicity in this trajedy fail if they can't raise capital on their own...without being subsidized by taxpayers through artificially low interest rates. if hey can't let their stocks go to zero, mangement lose their jobs, counterparties take big hits. the stock market would tank and some money market funds might break the buck but the lessons would not be soon forgotten by anyone...businessman, citizen or politician. adversity is a great teacher and a lesson well learned has great value. recovery would be faster and stronger than anything we're likely to see given the fed's socialist approach, which reinforces exactly the wrong concepts.

anyone who thinks the fed acted out of altruism doesn't appreciate the politicization of the fed over the last 20 years. it is "the establishment" including every congressman, senator and administration, that loses big in a financial collapse. no government-appointed official would bite the hand that feeds him, including the federal reserve.

2008 Aug 12 11:29 PM

[Jimmy Lathrop:]

GSEs were established to pass on savings to homebuyers to make mortgages more affordable. Adjusted for real inflation, the savings passed on are negative. If the GSEs didn't exist, the market would have to adapt and find creative solutions to sell mortgages. But who has time for that when you're too busy lobbying? The GSEs are on the canvas but the ref is counting slowly much to the disdain and howling of the crowd. Eventually, the ref will have to hit "10" and the world will not stop. All of you GSE touters can go on and put your stock in BAC or some other "quasi-government" entity to make yourselves feel better.

2008 Aug 13 07:05 AM

[venividivici:]

Good healthy debate.

2008 Aug 13 08:33 AM

[Aryamehr:]

If the Federal Gov't allows Freddie or Fannie to go bust, especially when they know damn well they are partially responsible for their malady then you can rest assured attracting foreign money at incredibly low interest rates is going to get much harder. Owing to this I beg the question on how in God's great name are we going to service our national debt? Our nation unfortunately doesn't have a natural propensity to save and if foreign capital dries up the only alternative left, short of very high interest rates, would be to print more money, hence depreciating the real value of the dollar at an accellerated pace.

FRE & FNM have 45% of the mortgage debt of this country and they currently facilitate 70% of originations. Their role in the U.S. economy is priceless and replacing them with another institution would be far too costly for the gov't or nation as a whole. The solution to their problems is simple, just cut the dividend and wait for the market to correct itself. Which we all know will happen within 18 months.

2008 Aug 13 12:01 PM

[Aryamehr:]

It is unequivocally obvious that the main culprits behind the financial crisis are at the very top of the food chain; Mr. Bush and the Federal Reserve of Mr. Greenspan. The GSE's only facilitated what was asked of them and they used the full lattitude of their madate to effectively do their business. Now that the Fed and Mr. Bush's profligate actions have manifested their ominous facets everyone is trying to point the blame for the financial crisis on the GSE's. Don't forget that the GSE' s played a very important role in stabalizing the mortgage industry and facilitating mortgages to remote areas that would have been difficult or virtually impossible to acquire without them.

Owing to the aforementioned and more, the powers to be had no alternative but to change their implied support to explicit support of these enterprises.

Remember, what happened to Chrysler and why the gov't bailed them out? The results of what happened to their stock after a little while should manifest what will probably happen to the GSE's.

Patience is more rewarding than ingenious.

2008 Aug 13 02:08 PM

[icandoitdon:]

aryamehr:

you fear that the cure is worse than the disease. it isn't.

FNM and FRE are the poster boys for the disease that infects this once great country...it is called leverage. our pathetic inability to finance our own country mirrors what has happened in the economy at large, with financial institutions having insuficient equity to support the underlying risk of their business models, and individuals lacking the assets to support the consumer and mortgage debt they carry. that realization among investors has set in and the unwinding of the excessive leverage that has supported our economy for years is occurring.

those who don't have a collective pot to piss in want to preserve the status quo. they like the notion of buying a house with nothing down because they risk nothing. they don't give a damn about subsidizing the very financial institutions that caused the rot because they don't have cash assets at risk except their overpriced house, which is sinking in value.

you lament the risk of losing the cheap foreign money that finances those things we can't afford as individuals or a nation, as if that's the norm. it isn't. the norm is to live within your means, using credit judiciously. if we can't put our economic house in order as a country or as individuals we're not only undeserving of cheap credit...we're undeserving of credit at any price.

Paulson's wishful thinking that FNM and FRE survive in their present form isn't going to happen...the markets have made that clear. FNM and FRE will likely be nationalized. taxpayers will absorb losses on the paper they hold. when the dust settles they will be again be resurrected as public entities, with one important distinction...they will lack government backing of their debt. that's how it should have been and that's how it ultimately will be.

2008 Aug 13 02:18 PM

[madasiwannabe:]

Good debate. There's a lot of blame to go around, but let’s not put it all on Freddie and Fannie. They are overseen by OFEHO and it is OFEHO that sets their limits. You can't blame your kids for screwing up when they are following your rules. I also think it's important to point out that those who now call for the GSE's demise are also the ones that created the situation and are now in the best position to profit from it. Let us not forget that then Chairmen Greenspan openly encouraged mortgage lenders to make loans available to everyone. When the banks ran out of money to loan and the GSE's could take no more, the limits and standards were adjusted. One of the biggest beneficiaries of those adjustments was Countrywide.

Those who stand to benefit are the credit drug dealers and their brokers that support our habit, and I’m not talking about the banks or GSE’s. Now that America is hopelessly addicted to credit, it’s an opportune time to raise the cost of the drug. (I’ll give you one guess what Greenspan does for a living today.) The erosion and eventual dismantling of the GSE’s will kick off the largest fleecing scheme every perpetrated. Who would blame the purchasers of our securities if they demanded higher rates for taking on obviously higher risk. The increase to our already financially stressed economy would be wide spread and catastrophic. Anyone that thinks they will not be affected is simply fooling themselves.

The issue isn’t what happened; the real issue is what we can do to fix it without destroying everyone, especially those that lived within the rules and within their means. Parroting the myopic views of the media is not going to do it.

2008 Aug 13 07:35 PM

[icandoitdon:]

FNM and FRE also had an obligation to shareholders in which it failed miserably because of overleverage. i don't give them a pass because they were doing a fool's bidding. guess who is the fool?

it's not just "fixing" the current mess...it's ensuring that the same thing doesn't occur again. toward that end, the existence of FNM/FRE in their current form, as paulson envisions, is a non-starter. let em go broke...wipe the shareowners out and let the subordinated debt holders take whatever haircut they have coming. when the smoke clears and taxpayers have antied up their tens of billions in guarantees, float a new IPO absent the guarantee of the federal government that got them into trouble in the first place. and let them finance their operations based on their stand-alone credit risk like any other private enterprise.



home ownership isn't a right. it's a privelege. that's what the phony and fraudie defenderslose sight of.

2008 Aug 13 08:55 PM