Fannie, Freddie: Beyond the Balance Sheets

From Kings 1, 19:11-13: 

The LORD said, "Go out and stand on the mountain in the presence of the LORD, for the LORD is about to pass by. Then a great and powerful wind tore the mountains apart and shattered the rocks before the LORD, but the LORD was not in the wind. After the wind there was an earthquake, but the LORD was not in the earthquake. 12 After the earthquake came a fire, but the LORD was not in the fire. And after the fire came a gentle whisper. 13 When Elijah heard it, he pulled his cloak over his face and went out and stood at the mouth of the cave.

The story of Elijah is a spiritual example of how investors need to demonstrate discipline and discernment.  Each of the seemingly apocalyptic events that occurred in front of Elijah could have caused him to react prematurely or fear something not worthy of fear. 

On a much more worldly level, such is the case with Freddie Mac (FRE) and Fannie Mae (FNM) preferred shares.  In the past few months, the din of negative assessments of the GSEs situation has been deafening.  Stories of representatives of foreign sovereign financial institutions calling Paulson himself to explicitly guarantee the US government financial backing for the FRE and FNM are accepted as truth.  There has been an unprecedented selling of FRE and FNM preferred share securities, over $12B worth, in just a few weeks.  For any smaller or non-government entity, this would be a sign that the corporation was worth no more than junk.  

Even more telling are estimates regarding the net worth of GSEs.  By many mark to market measures, there is negative net worth to the organizations.  No one really disputes this, but many market participants expect that this is grounds to seek bankruptcy proceedings for these entities.  The roar of the critics and investors disillusioned by the state of the credit markets expecting honest reporting and vindication for predictions of this outcome of easy credit is deafening.

Yet this is all noise.  The authority, the US government, has completely different agenda.  The US government must maintain the stability of the US and implicitly the US housing and credit markets.   The calculation of the net worth of FRE and FNM completely discounts the goodwill value of having a government organ able to keep mortgage markets from freezing up completely and starting the economy in a free fall.  To the government, FRE and FNM are one of the few remaining levers to keep the markets moving.  How much is that worth?  In a whisper, that value is beyond the value of any bailout cost in dollar terms.

click to enlarge

Source: QuantumOnline.com

Why keep value in the preferreds and even the common then?  Scream any profanity appropriate about how unfair it is for investors not to pay for their faith in insolvent corporations, but what about the intangibles?  The biggest currency the US government has right now is faith that it is a good place to invest and that it will pay whatever debt is owed.   A tremendous amount of the preferred securities were purchase based on the implied backing of the US government.  To repudiate that assumption at this point will to risk total loss of faith in the US government as debtor.  How much is that worth?

Why hasn’t the authority spoken to revive faith in these institutions and let all this noise come out speaking of their demise?  In the financial classic Manias, Panics, and Crashes: A History of Financial Crises, the author, Kindleberger, explores how financial crises unfold and what is the options of those seeking to alleviate the crisis.  A reviewer gives a synopsis of Kindleberger’s conclusion:

What, in the end, is Kindleberger's moral? …. The solution, he believes, lies in having a lender of last resort. The trick, of course, is to avoid moral hazard and prevent the public from gambling due to the reassurance of a lender of last resort. The answer is ambiguity: the lender can come in and save the day but investors should never be certain that help is forthcoming.

Elijah never knew how many dramatic events would occur before he would hear The Lord speak.  Such is the case with FNM and FRE, there is no motivation for the government to establish a floor because of the risk of inspiring moral hazard in the market is too great.

In the end, some time soon the cacophony of market opinions will subside and the market will realize that FNM and FRE serve a purpose much larger than just what balance sheets suggest.  Then, at that grand final moment, the authority in this matter will honor the faithful.

Disclosure: The author is long FRE preferreds

Comments

[Ishortyou:]

Do NOTHING it will correct on its own, just give it some time.

2008 Aug 24 08:08 AM

[waldipup:]

Nobody knows what the freak they are invested in.

I personally have seen complete junk go into their portfolio.

I'm a nobody , so multiply that by (how many others?)

There is no way to value this entity.

It may be hopelessly technically bankrupt , with the only positive , as the writer points out , that the government will add it to its welfare list ,
along with everything else at this point , to keep it floating ,

And then at some magical point in the future real estate prices will rise and it will become viable again.

It's applicable that the writer posts in biblical fashion , because that's what this is at this point -

A "belief" that the gov can carry everything on its back , no matter the load , and everything will work out ok.

You can get 5% on a 4 or 5 year cd , (also gov. backed!) , and there are other beaten down stocks with potential to invest in not dependant on government welfare to survive.

Just my opinion.

2008 Aug 24 08:53 AM

[User 113229:]

Finally, some light in the wilderness.

2008 Aug 24 10:50 AM

[montyman:]

An article on FNM/FRE written in biblical fashion! LOL

What this means is that only God Himself could save FNM/FRE

2008 Aug 24 10:58 AM

[ksmithdc:]

Agreed with Ishortyou.

2008 Aug 24 11:01 AM

[gurby:]

Politics aside, and inspite of what Alan Greenspan and Warren Buffett have said, the initial FED's fannie and freddie bailout plan is indeed to essentially safeguard taxpayers rather then investors. Those who say it is sell out do not understand the real maths. Taxpayers stand to loose much much more if Freddie and Fannie are nationalize and not to mention the cascading fallout to mortgage/insurance markets and the trust people have in the administration to honor its GSE institutions. The markets know this and therefore want more assurances from the govt that they will let the markets find the equilibrium rather then nationalize and leave investors with nothing. If the markets do not participant, the taxpayers stand to loose the most as GSE loans are clearly sovereign loans. The govt will have to come out with much more and with no assurance of getting back anything in return.

The other alternative of selling out to private equity with zero value to current investors will also be a fatal error. People will loose faith in all the assurances the govt and Freddie and Fannie have given to invest more in these companies just a few weeks ago. The trust once lost will take a long time to gain back. There is no gaurantee that private equities have national or broader social concerns. Their priority is going to be their own stockholders, who essential are again the masses.

The market is looking for firm and decisive actions to show that the govt is prepared to invest in Freddie and Fannis in the short term to shore confidence against the poor negative sentiments. Freddie and Fannie are not yet bankrupt and their business models are still relevant albiet in certain rough patches. with some short term help They have enough cash returns and expenses to roll over and navigate from the current crisis.

Time is of essence. The FED need to act fast and decisively.

2008 Aug 24 12:19 PM

[msgtb:]

Let the common and preferred stock go to zero and have the U.S. Government back the mortgage part only. Take them into receivership and create a resolute trust to accept the foreclosures like was done in the last S&L meltdown. These are publicly traded companies and deserve to go broke. The reason that moral hazard continues is that government backstops the losers rather that letting them fail, like should happen in a free market. Write your congressman and senator to make sure that taxpayer money is not spent to bailout these failed companies. This is an election year and think of the future generation debt if these company's are bailed out with taxpayers money. God bless America!

2008 Aug 24 01:17 PM

[Danny Newton:]

I have never seen an example of using intangibles as a justification for the government losing money. In transportation, an attempt was made to use external benefits to justify policy decisions. The value of human life, accident costs and medical costs were in the mix for years but then the value of human life was raised at a rate that was six times the background inflation rate, some computer programs were developed to include air quality considerations. The whole system collapsed because everything and anything was suddenly justified by the overwhelming "benefits." External benefits and intangible benefits are an open invitation to abuse of taxpayer money. Government spending can be turned from productive to consumptive without policies that concentrate of internal benefits.

Sewage treatment has enormous health benefits but even that can be run into the ground if treatment is designed to take water quality back to the Garden of Eden. Convention centers might be good or bad investments or even stadiums could be good ideas but, the real losses are in the calculation of the value of the intangibles.

We have at least four counties here in Tennesseee that have their idle cash in Freddie Mac and Fannie Mae in spite of the fact that it is illegal according to the Comptroller Generals Office. It is OK to buy US bonds though.

2008 Aug 24 02:16 PM

[PhinT:]

Nice to see a positive comment with the short folks running a muck lately destroying the market…. I am long on FNM as well (23% of my entire portfolio)… I trust the Government will have several investigations and throw some folks in jail for this continued onslaught of rumor mongering destroying the financial market…

2008 Aug 24 07:38 PM

[wombat 708:]

FRE and FNM go to zero. Why bail out shareholders, either common or preferred? It only adds to the cost. $250,000,000,000 short term is due soon. Why add to the cost. Shareholders took all big gains over 20 years, now some take the losses. That is called capitalism.

2008 Aug 24 10:27 PM

[mhspring:]

If both GSEs are allowed to go under what happens to the US mortgage market? What entity will step in to perform their function of buying mortgages from originators? I suspect that there would be a significant period of time during which the housing market would come to a screeching halt because only those who don't need a mortgage to buy a home would be able to get one and then at a significantly higher rate. Wat would happen to our economy then? What would happen to all of the banks who count GSE pfds and bonds as part of their capital?
In an ideal world, there would be no GSEs. We don't live in such a world so we are stuck with them and have to keep them afloat at least until the housing market recovers. The common could go to zero but the consequences of letting the pfds go bust will be dire of the loss of bank capital.
BTW: how much of the current crisis is caused by institutions having to mark-to-market securities that are clearly being held to maturity?

2008 Aug 25 05:34 AM

[Stan Muse_:]

The real intangible is that we do have a focal point in FNM and FRE that the government can use to prop up the housing market with a bail out. What if FRE and FNM did not exist and this cancer was just spread throughout the entire body of all financial institutions? Then there would be no hope of the government being able to do anything. We must keep FREand FNM in tact in order to keep a handle on the mortgage problem. See seekingalpha.com/artic...

2008 Aug 25 09:41 AM

[robert.b.fe...:]

What is the missing link? Well it's the fact that the Government created this mess by pressuring the mortgage markets to lend more in order to get more people invested into private housing. That has been a major talking point of the Bush administration the number of new home owners was a show piece. Unfortunately some greedy banckers like Mozillo the magician went a little overboard. Now having created a monster they are obligated to deal with the fall out.

2008 Aug 25 10:57 AM

[satguru:]

Well I guess you could be right. The only person I know of that has GOD telling him what to do is G W BUSH JR. He actually talks to GOD or rather GOD talks to him. I am now going to buy some FNM preferred just having sold all my FNM bonds. Thanks and GOD bless you. I will be rich - Ha! Ha! laughing all the way to the bank.
Good luck to all the losers.

2008 Aug 25 03:50 PM

[Ebi:]

Agree with montyman, the US Government is not God and never will be.

2008 Aug 27 06:50 AM

[Lockstep In...:]

The US government is never intended to be represented as God. The analogy is between authority figures. This reference happens to be from the Bible.

In retrospect, I put too much faith in the government to enforce confidence in the economy and government serving institutions by supporting the shareholders who invested in it.

There will not be press releases for the $32B in preferred equity that has been wiped out on bank and investor balance sheets in mark to market losses. But it will definitely show up in other places and I am sure there will be much more caution in putting faith in companies chartered by the government in the future.

2008 Sep 09 11:49 AM