Fannie/Freddie Rally: A Product of Fed Intervention

This week’s debt offering by Fannie (FNM) and Freddie (FRE) sparked an intense rally in the stocks of the two companies.

There is not much good happening right now in the business of Fannie and Freddie. They have sold debt before, like in their better days. In fact, investors who picked up Fannie and Freddie papers this week would have been foolish to walk away from three-month notes yielding 2.58 per cent. Mind you, these instruments have some kind of government guarantee attached to them that (from what these investors like to believe) must cover the near full percentage point over Treasuries. I am wondering if that auction raised an eyebrow or two at the Treasury Department, or at least, raised some concerns regarding the Treasury’s own debt offering. But the Fed doesn’t seem to want to take action. This gives investors the perception that the markets will have to play themselves out.

But ironically, or sadly, it is the Fed intervention that is allowing for Freddie and Fannie to have a market, and as a matter of fact, to even have enough capital to operate. So far, the companies appear well enough capitalized to keep running their “real-estate-crash-induced” shrinking balance sheets, as losses, dollar by dollar, through their income statements. Plus, the profits generated from current operations and ongoing debt sale will provide sufficient cash flow and added liquidity to allow for business as usual. And even better, they haven’t reached negative equity yet.

So what does this mean? Well, let’s look at the newly formed management team at good old Fannie. They must be eagerly anticipating future debt offerings.

Why? Well, because it is the absurdity of that kind of debt sale that will determine at which point the government is going to interject loud and clear. “What exactly are we guaranteeing here?” I am not sure how the spread on Fannie or Freddie paper will move, but it can be enough to send more shockwaves through the Fannie and Freddie hierarchy and all the way to Washington.

Another question is going to be how concerned the Fed will be with the credit worthiness of newly issued paper. The debt offering certainly didn't seem to reflect that the concerns lie with the debt holders. So how does this whole notion of the much talked about credit risk come into play here? Well, one can assume that if the aforementioned shockwaves won’t reach Washington, it will eventually be the creditors themselves who will.

Disclosure: none

Comments

[bbzz24:]

this is a pure arbitrage play yielding 0.58%: sell treasuries, buy debt already explicitly backed by the treasury and pocket the spread.

2008 Aug 28 08:01 AM

[PhinT:]

I would hardly call this week an “intense rally” of Fannie and Freddie… the stock is sitting at $6+… From my perspective, the news media has lead these stocks to the brink of failure (also the Market) based on media hype and rumor mongering where emotion and “opinion” were the drivers not facts…I am still waiting for an article or blog that just states the facts instead of someone’s attempt to manipulate the Market for personal gains or ego… Is Chicken Little right in that “the sky is falling…?”

2008 Aug 28 08:03 AM

[gatersaw:]

I got more out of the comments of this article. Thanks bbzz24 and The Truth Seeker. I knew there was a reason I came to SA.
Thanks for the common sense comments, guys.

2008 Aug 28 08:45 AM

[ArchDukeFer...:]

Well, if the FDIC has explicitly guarantee Fannie and Freddie debt then the common stock of these two GSE will survive. Reason, Fannie and Freddie will have the ability to issue debt to pay for any contigency. There is no moral hazard.

2008 Aug 28 09:00 AM

[Dan Schmeidler:]

The Feds are doing everything to keep FNM and FRE debt offerings alive and well. Heck, they even participate in the very purchase of its debt. At some point the Feds will have to look more closely at what exactly they are picking up at these offerings. I believe, they will also take clues from previous creditors coming to the table, hence future debt offerings.

2008 Aug 29 05:36 PM