Fannie, Freddie Shareholders Will Be Left Holding the Bag - Barron's

"The almost inevitable government recapitalization of Fannie Mae and Freddie Mac will likely wipe out investors—and management," Barron's magazine says.

Assuming their assets were liquidated now, based on their fair-value reporting, Freddie Mac's (FRE) net worth would be -$5.6B, while Fannie Mae's (FNM) would fall to just $12.5B, from $36B at year-end.

But Barron's Jonathan Laing says the firms' fair-value estimates "may overstate the value of their assets significantly." A different calculation puts each about $50B in the hole:

• 'Deferred tax assets' account for $36B of Fannie's net worth, and $28B of Freddie's. These could disappear if the company is sold or goes into receivership.
• Instead of repurchasing soured mortgages, they have begun making interest payments to bring them current - an expensive trick that does little more than postpone the inevitable losses.
• Less generous assessments of Freddie's $132B in private-label subprime and Alt-A loans would slash its net worth by another $20B. Fannie's $8.9B in credit reserves won't fully shield it from future losses on $36B in seriously delinquent mortgages on its $2.8T book.

A Bush insider says the GSEs are being 'jawboned' by the Treasury and their new regulator the FHFA to help them raise money. Privately, the administration doesn't expect them to succeed: Only a capital raise of $10B each would be credible. But who would plunge that kind of money into companies that have market caps of just $8.5B (FNM) and $4B (FRE)?

The source says that absent of a successful capital raise, the Treasury will pump money into the GSEs in exchange for "preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends."

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Laing was early to the show in March when he said:

[Fannie's] balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis. And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie's solvency.

At the time shares were trading for $26.50. Friday they closed at $7.91. We'll see where they open Monday.

Of note, Legg Mason (LM) and its star manager Bill Miller have been bulking up on FRE. "Bill Miller is going to look like the smartest guy in the room or the dumbest," StreetInsider.com's Lon Juricic says.

Comments

[investor88]

It only seem fair that shareholders of Fannie and Freddie should be left with nothing if public money is used; shareholders got Fannie and Freddie where they are today and investors must take the consequences when things fail like Enron going bankrupt. From the facts presented in the article it seems there is no easy out for Fannie and Freddie except taking the necessary medicine.

[noni1]

You people just dont get it. Barrons doesnt get it. Eli doesnt get it. FNMA/FRE will survive "in their current form", with existing shareholders intact, to not only preserve the equity built up over the multi-decade timespan these companies existed, but to keep the respective employees 401ks intact. Why is that important? In order to keep these entities "in their current form", the existing employees must do their jobs! If someone just lost WHAT IS LEFT of their live savings, thats not much incentive to stick around is it? Demoralized workers anyone? And didnt you notice that Barrons didnt state its government source? Please. Rumors and lies and the veiled hand of Soros, who will be furiously covering next week. Sorry shorts, game over.

[madasiwannabe]

Wiping out shareholders is a great plan. Since most of the shareholders are mutual funds and banks, that would put the burden on the baby boomers and cause massive writedowns for the financials. Go look at the investor list. If shareholders get wiped out, how do you suggest we go about attracting foreign securities investors? The GSE's are already contracting because of the lack of investors which is in turn causing a liquidity crisis in the financials.

Doesn't anyone think a takeover would cause a run on the GSE's by investors that currently hold mortgage backed securities? I sure as heck wouldn't keep my money in something that is not worth the paper it's printed on (mark to market valuation, remember). Then what? How do you pay back $5T to investors that no longer want to be associated with high risk securities? Let me guess, put it on the Fed's books? Adding $5T to the existing $11T will surely have a stablizing effect on US backed instruments.

Any intervention by the Fed's will cause a cascading catestrophic collapse of the entire financial system, which will lead to the biggest depression the world has ever seen. If that's what your looking for, a takeover would be perfect. If not, the only real option is to allow investors to continue to shore the GSE's up until they recover, then we can look at options to protect our future.

[icandoitdon]

talk about not getting it.

the "too big to fail" argument doesn't apply to equity investors. anyone who thinks the government will take pity on them in a bankruptcy/receivershi... is utterly naieve.

the only thing that can save FNM and FRE is a sudden reversal in the housing market and that isn't going to happen. FNM and FRE need equity capital to survive. they can't get it from public or private sources at any price and as a consequence these companies will have to be nationalized. good riddance to a bad business model.

as for an intervention by the fed causing a collapse of the financial system, hello?. the fed has already done everything but nationalize the entire financial sector.

game over for shorts? that's laughable.

[Carlos54]

Note that probably the people posting here in favor of a bailout of the shareholders are probably those that bought at a discount hoping to make a killing. This is America. I would be outraged if even a penny went to existing common and preferred shareholders. Individuals should just eat the loss and stop whining. Institutions that held common or preferred stock can be given liquidity (read very very senior LOANS) from the fed that would take priority over their own shareholders---many of which now are foreign.

No way should the US governemnt bailout the shareholders and tank the US Treasury

[madasiwannabe]

What part don't you get... any intervention by the government will tank the treasury. Barron's article is missing one key fact, mark to market accounting on loans doesn't make any sense.

If you have an auto loan and your car depreciates, does the institution that holds your loan take a writedown on the loan? NO!!! It worth exactly what you pay in principle and interest above their cost.

They peddle their BS to sell papers, because everyone wants to watch a train wreck. The truth is they are well capitalized and have no problem making money.

[Jimmy Lathrop]

I can't agree or disagree with the thesis of the article. But I can say with a certain amount of accuracy that the fate of the GSEs lies in which party wrests control of Congress and the White House in November. By the way, has anyone noticed how pale and thin the President has been looking lately, and how inversely, even with heart surgery, how hale and hearty Mr. Cheney seems? Disclosure: member of the GOP.

[Egg]

One point of contention:

The idea that FNM and FRE common stock will be left worthless after they raise the necessary capital to survive has been common knowledge now for weeks/months...yet the stock refuse to trade down any further.

This somewhat reminds me of the day BSC went under and the stock refused to trade down near 2 and rose all day. I remember David Faber (CNBC) actually chastising people on camera for paying anything over 2...then lo and behold a week later the stock was worth 10. The people in the know knew despite Faber.

And it's possible the people in the know know about FNM and FRE and that the government will toss a small bone to common shareholders, too.

That being said, I cannot bring myself to buy since I'm not in the know.

[Lost Soldier]

1. The Barron's article is nothing more than a repeat of an earlier article. 2. The Democrats are not calling for wiping out the shareholders, only the Bush White House is thinking about it and talking to the press. 3. Congressman Waxman has already raised the issue of White House statements damaging these companies and wants to hold hearings. This weekends Barron's article guarantees it. 4. Don't kid yourself that the bonds are safe, they will be dumped by risk adverse bond holders who will not want to wait around to see if the government wiping out the equity, preferred and lower rated debt is enough. With thousands of bonds to own, why own the ones of companies the government is trying to shut down. The wipe out will bring systemic problems for sure, and that is what Paulson wants to avoid.5. Fannie and Freddie can raise capital by selling off some of their retained portfolios. As the portfolios get smaller, their regulatory capital requirement becomes smaller. They are raising fees and buying good mortgages now at a positive net interest margin. Their regulator is not likely to suddenly demand a change in their accounting treatment that will wipe out all of their capital, so discussions about recognition are academic. 6. Barron's is a Dow Jones publication, just like the WSJ and has a long standing opposition to the GSEs. They are talking their book.

Bottom line. All Paulson has to do is make it to January to leave with a legacy intact. If he acts, it will smear him as having brought about a cataclysmic economic event that may not have been necessary.

[madasiwannabe]

You take the cake Mr Hoffman. Not only did Barron's just republish their March 8th article, so did you. You know as well as anyone that there are a lot of wealthy people that will become even more wealthy upon the demise of the GSE's, yet you make it sound like some breaking news about Fannie and Freddie. You should be ashamed of yourself.

seekingalpha.com/artic...

[User 229496]

fre risk management should be fired


On Aug 18 07:27 AM madasiwannab e wrote:

> You take the cake Mr Hoffman. Not only did Barron's just republish
> their March 8th article, so did you. You know as well as anyone that
> there are a lot of wealthy people that will become even more wealthy
> upon the demise of the GSE's, yet you make it sound like some breaking
> news about Fannie and Freddie. You should be ashamed of yourself.
>
>
> seekingalpha.com/artic...

[pickaroonwyo]

Next question: When will Bernake open the discount window to pawn shops?

[andys2i]

More media hype. Put on your seat belts again and enjoy the roller coaster ride in the next chapter of the thriller/horror story that is the Financial Crisis. For your safety another government bailout maybe on the way, thanks once again to the ever suffering American tax payer. Of course the investment banks and wall street vultures (i.e. hedge funds) will continue to make money shorting the shares of these financial companies as they go down, and also when they have their obligatory spike in a couple of days.

[TBill]

FRE & FNM were bad ideas from the start, and there were people saying so. Took decades to see why. Hey, I lost money in them too. Now the question is who pays for the mess? Shareholders [me]... government [you]? I'm thinking both, with the government gobbling up the companies. Polititians like to nationalize things, and then they can run at a loss all day, and run the printing presses all night to pay for it. All in the name of 'the greater common good', don'tcha know.

[msgtb]

The March 8th article was probably just as relevant today as it was then. The financials are not at a bottom or anywhere close and the GSE's will fail and be taken over by the U. S. Government. No change!

[jackeast]

Solving the Housing “crisis”.

A. In order to solve the crisis a quick look at the underlying issues of the crisis are important.

1. The rate of increase in housing prices was artificially accelerated by the availability of high risk loans. The loans were high risk in that people could not afford to pay the principle and interest while maintaining a quality of lifestyle commensurate with the property they were purchasing. Risk increased as the available cash flow of home owners was not enough to create capital reserves to offset future risk. The loan types were generally variable rate mortgages that even financially savvy borrowers could not adequately assess risk.

2. Supply over the last few years was increased in response to the artificially accelerated rate of home price increases. While the rate of home prices increases was high and capital was easy to come by a large portion of the pool of potential buyers entered the pool of buyers. Those “potential buyers” who transitioned into the “buyers” pool were forced to purchase homes that would normally have stayed out off the market or been eliminated from the market due to development, nature, or disaster for inflated prices. So while these homes in “normal” markets would not have been marketable or tradable in a period of “abnormal” markets they became commodities that were prized by two classes of buyers. The first were marginal buyers who generally would have stayed in the “potential pool” of buyers and “investors” who desired to purchase and “flip” with marginal and minimal “upgrades” to the properties. Further, the accelerating pool of “new” homes added to available supply making the calculus for home buyers more complicated. i.e. Pay slightly more for a new home or slightly less for an existing home. More and more buyers were choosing the former over the latter. This increased risk and resulted in builders having competitive advantages over existing homes. The competitive advantage resulted in more new home construction. At the same time the dynamic of the marginal buyer and investor and now exacerbated by those seeking to “trade up” increased the supply of existing homes. A general but not unreasonable increase in basic commodities created situations in which marginal buyers (i.e. those that recently transitioned into the buyer pool because of the previous dynamics) became unable to service their mortgage debt. As these properties entered the market as sell before foreclosure the supply increased even more. This portion of the supply was marked at very close to cost causing a DECELERATION in the median price of homes in at risk markets.

3. The availability of renal properties became reduced as they became converted to finance and buy properties. This began to drive up the cost of renting. As the cost of renting increased, the calculus of buy versus rent increased the number of those transitioning from “potential buyers” to “buyers”.

4. Eventually the pool of available buyers became maximized to the market conditions and there were no new entries into the demand market. At this point demand began to decelerate. All those who could trade up had done so. All those who could buy a house to live in had done so. The available leverage and capital of “flippers” was maximized.

5. As demand decelerated, the time it took to sell properties increased. Loan brokers and financial institutions as well as construction firms and sellers attempted to reduce this time to sell through special “fast track” loan programs and incentives. Eventually the only way to reduce the time to sell was to reduce prices. This reversed home price increases and began the process of accelerating decreases in home values in the system. As comparable homes were sold for less and less month over month investors began to question the actual value of the collateral behind financial instruments.

6. As interest rates reset on homes and the true cost of ownership began to affect marginal buyers a new class of supply entered the market; the foreclosure. While this class of supply had generally been available to the market they had generally been in demand by the investor and developer. The market could not absorb this extra supply and as housing prices had entered the phase of declining values already, these new entries resulted in drastic rates of declines in “key” markets.

7. Declining values of collateral and leveraging strategies by financial institutions resulted in decelerating returns on loan portfolios and even losses. These losses were identified rightly as due to the decrease in value of properties, which erased the value of collateral, the increasing costs of foreclosure, the decreasing revenue for loan generation, the decreasing interest payments from the pool of home owners, and the increasing cost of refinancing debt as the capital markets began to doubt the value of financial instruments in a new wave of analysis.

8. Risk insurance and cost of capital increased as the traditional backstop of losses, the insurers exited the market place. The scope and depth of losses in the insurance sector locked up the entire market place and made the cost of refinancing and capitalization such that losses mounted. The result was two-fold: 1) increased capitalization that reduced the amount of liquidity in the market and 2) increased cost of gaining capital at the retail level. The result was pushing a large portion of those in the “buyer pool” back to the “pool of potential buyers” and drying up demand.

9. With even less demand and an over abundance of supply prices fell at an even accelerated rate.

10. Psychology of the market place now dictated that the entire pool of buyers analyze the risk of entering a falling market. At this point the cost of moving first may be the further erosion of the value of one’s home and missed opportunity to purchase higher quality at equal or less cost. The buyer market then became limited to those who “HAD” to purchase as a result of market conditions.

11. Interest rates for those financing and the information requirements (i.e. total cost) increased dramatically further eroding supply.

12. The end result is a stagnant market of buyers and sellers and financial institutions with an increasing portfolio of under or non performing loans making all the financial instruments that are supported by the market of an uncertain value. This has further eroded both availability of capital to fund purchases and the ability of financial institutions to finance its debt increasing threats of insolvency. As certainty and confidence is eroded the problems become worse and a feed-back-loop results.


Now that the underlying process leading to the current “crisis” is understood some solutions can be formulated.

B. Reduce supply.

Stabilizing the values of homes is essential to create certainty as to the value of securities and collateral. It will also change the calculus of buyers who are staying out the market because of hopes that they will be able to buy more for less. Reducing supply would also decrease the time that homes are on the market creating conditions that will decelerate the rate of foreclosure. This too will create conditions of certainty and solve the under-and non-performing loan problem.

There are several possibilities for reducing supply and they include:

1. Offering grants to localities to purchase properties to turn into green-space or to place in land/property trusts for later development.
2. Offer terms that would allow the refinance of properties to reduce the foreclosure of homes. Terms such as 40 year or 50 year mortgages at increased interest rates with provisions that state that the property cannot be sold or transferred for 2, 3, or 5 years. The lender can force refinance instead of foreclosure.
3. Market clearing houses can be established where people in foreclosure can have the option of “trading down”. Financial institutions can offer homeowners the ability to refinance into a lower cost home removing it from supply, keeping a marginal home-owner in the home owner pool and maintaining the very highest valued properties in the supply system. These properties would be the most likely ones to benefit from the “trust” green-space programs mentioned above. They are also the most likely to be successfully managed in foreclosure.
4. Financial institutions should enter into property management agreements utilizing programs such as the Defense National Relocation Program that offers property management services for relocating home owners. Properties are rented. By transiting homes from the sale/finance pool to the rental pool two things are accomplished. 1) Those entering the rental pool may be able to remain in their homes as renters paying less cost such as insurance and local property taxes. These costs are transferred to the lender. However, with rental rates as they are, it is possible that even with decreased rates due to increased supply that the lender will be able to cover the costs with rents. 2) Financial institutions are able to maintain the book value of their collateral (real property does not suffer from mark-to-market issues) and still maintain a revenue stream. A provision for refinance and repurchase may be included in the lease/rental agreement offering the potential for future revenue and a ready market of borrowers when future conditions improve.
5. Increase the costs associated with selling a home. For those home owners who cannot show cause for sale( i.e. not in threat of foreclosure as certified by their financial institutions) will pay a tax penalty on the sale of their home regardless of whether they make a profit or not. Something like a .005 tax on the total proceeds of the sale payable into a “Green Space and Trust” account for giving block grants to localities for purchase and clearing homes. This could be in effect for 2 or three years while the market cleans itself up.
6. Decrease the costs of home purchase if one is not also selling a home. Offer a tax rebate equal to the total costs of closing (minus down payments and points) payable in 5 years if the home is owned as a primary or secondary residence for 3, 4, or 5 years. The payment can be prorated based on the length of ownership. The payment can also be divided into two segments, one payable to the lender as a principle payment and one payable to the owner. The rebate could be recouped by the federal government at a rate equal to 10% or 20% a year from the mortgage tax deduction in the years following the payout.
7. Increase the regulatory requirements to offer adjustable rate mortgages. For instance, increased equity in the home through higher down-payments, or increased monthly payments into an “Interest rate adjustment account” to offset the affects of interest rate increases.
8. Allow new home construction companies to purchase their own inventory at reduced prices to claim the loss on their taxes and to not pay sales tax on the properties if held for 2 or 3 years.
9. Allow construction companies and owners of residentially zoned lots to “charge off” or deduct an “opportunity cost” equal to some percentage of the assessed value of the land if the land is undeveloped for 2 years after the deduction. If developed then the individual or company has to pay back the savings resulted from the deduction + 20%.

C. Close the gap between cost of capital for the financial institution and the return on loans given.

1. Embrace the fractured pricing of the housing market by creating new loan segments. Break the housing price market into segments of 100K each in which each higher segment has higher real interest requirements. For instance on a 30 year fixed, the “base” bracket may be between 0 and 100K and equate to the 5 and 6 % range. From 100 – 200K the interest may be between 6 and 6.5% range. Between 200K and 300K the rate may be between 6.5 and 7%. Over 300K the rate may come back to between 6 and 6.5%.
2. Restructure equity requirements based on tiers or categories of loans. For under 100K the equity requirement may be 0%. From 100K to 200K the equity requirement may be between 5% and 10%. Between 200K and 300K the requirement may be between 10% and 15%. From 300K to 400K the requirement may be 20%. Over 400K the requirement may be 10-15% again.
3. Extend the period of repayment to reduce monthly payments on existing loans without refinancing, sort of an automatic renegotiating of terms. By extending the period of the loans and reducing principle payments it decreases the likelihood of default but increases the total expected interest payments to the loan. A 200K loan at 7% moved from 30 to 40 years would reduce the interest and principle payment from $1330 to $1242 a month.
4. Use savings from Dividend Cuts and equity offerings to reduce debt through retirement and repurchase. Repurchase of low quality debt at prices lower than issued with higher quality debt issues and cash would reduce borrowing costs for institutions.
5. Reduce leverage from the current 3:1 (for FRE) to 2.5:1 or less through the process of retiring debt and building cash reserves.
6. Increase cash flow to reduce borrowing requirements. Renegotiate mortgage terms to allow interest reductions, special incentives, and benefits for increasing principal payments.
7. Increase and capital cash flow to reduce borrowing requirements. Encourage voluntary increases to ESCROW and manage ESCROW accounts like Debit Card accounts. Pay interest on excess escrow balances and charge fees for the use of the account. Fence ESCROW DEBIT Accounts as capital reserves not to count in leverage decisions so that a “cushion” or “emergency reserve” of capital exists.

D. Increase Demand

1. Allowing the cashing out of 401K and IRAs for the purchase of homes if the family is “trading down”, the refinance of a home if lived in for more than 1 year and will live in for the next 5 without penalty, or the making of mortgage payments if in foreclosure and have lived in the property for more than a year and will live in it for more than 3 without penalty. If a family uses these funds then the financial institution has to forgive all interest and fees related to the foreclosure proceedings.
2. Stabilize the value of homes through the previously mentioned actions in order to eliminate the tendency of current buyers to wait for a better or lower price.
3. Provide grants and tax incentives for investors to purchase “distressed” properties and to transform them into green spaces.
4. Provide tax incentives for investors to purchase properties in foreclosure, to hold them for 2 or 3 years and then to redevelop or sell them. The incentive could be NO tax on the profit, a tax loss on the purchase that is then offset by a gain when and if sold, or any other program.
5. Allow the purchase of lots zoned for residential single home construction to be held for 3 years. At the end of three years the lots may be developed and no federal taxes paid on the assessed value of the land when sold, only on the property built on it.
6. Allow companies and individuals to purchase residential lots from themselves and to not pay federal taxes on the profits from the assessed value of the land if held for 3 years, only on the value of the property built on it.


E. Accept Losses to reduce Losses

1. Allow the “forgiving” of a % of an outstanding mortgage coupled with rate and term adjustments in order to reduce monthly payments and bring mortgage rates in line with actual values. The owner will pay taxes on the forgiven amount as income, the financial institution accepts a “loss” less than foreclosure, and the terms of the financing are transformed to create a new lower risk asset. For instance: 200K at 8% on a property worth 170K (for whatever the reason for drop in value) with 27 years left, turns into a Mortgage for 180K at 8.5% for 40 years saves over $200 a month when reduced payments and re-assessment of the property and the corresponding tax savings are taken into account. The government collects income taxes on the $20,000.00, the financial institution takes a tax loss on the $20,000.00, and instead of losing 1/3 or more by Foreclosing the financial institution only losses 10% on the revaluation and increases by .5%.
2. “Donate” distressed properties to localities for them to turn into green spaces or rental properties for low income persons. These properties can be “written off” at a value equal to the foreclosure costs and balance of the mortgage.
3. Offer programs by which local communities can purchase/finance distressed properties for destruction/rental/gre... space initiative/business development. For instance, a distressed property in a community could be refinanced under a special community works program at a low interest rate to be paid for by a locality such as a city or even a neighborhood corporation. A group of 25 home owners take partial (4%) ownership of a property that is foreclosed in their neighborhood that is then rented to own to a child care provider at a cost per month equal to the mortgage. While the child care provider may not have the capital to purchase the property the community does. The child care provider then provides care for the community and locality at market rates. This could be the same for any type of community home based business, a medical clinic, or even a library or dentist.
4. The property could be financed by a community and be torn down at cost to the lender in exchange for the community taking a refinanced stake to turn the lot into a neighborhood playground, green space, or held in common for later sale. On a 200K home each resident of the community (if 25 were included) would finance $8,000.00 over 30 years at 5%, or less than $50.00 a month. This may be added to a community association dues and the federal government may grant tax deduction status to the interest and any profit from the use or sale of the lot/property. The amount may be managed on an individual basis by the loan provider. 25 low risk loans at the price of 1 HIGH RISK loan. $50.00 is a small price to pay to maintain the value of homes in a community. And the cost is borne by the community that benefit from a maintenance of value. This also reduces supply and increases demand.

[Carter in Dallas]

Jackeast,

I think that's one of the sanest proposals I've read so far and I'm genuinely impressed. Please tell me that you're speaking to SOMEONE with political influence SOMEWHERE and that your proposals are "under consideration".

[WEBISKING]

Buffett said on CNBC that these stocks can ot be helped by private equity .Nuff said when he says they are not solvent ad were run ineptly and dishonestly that speaks moutful he owned them until 2001 and spokeof their excesses then