Exactly 13 months ago, I shared my very pessimistic views in an article entitled: Ben Bernanke's Initiation: Flashback to 1987. I conveyed a few of my concerns, including an untested Fed Chairman, an upcoming presidential election that would necessarily lead to a change, M&A activity that had surged, a high "real" interest rate, narrow credit spreads, consumer confidence beginning to roll over, low unemployment, the faltering housing market, the 5th year of a bull market and the eroding value of the dollar. I concluded (emphasis added):
My advice (take it for what it is worth): Steer clear of banks and brokers, Fannie (FNM) and Freddie (FRE) and any company that needs to access capital (many REITS). Yes, these things are down a lot, but they can go down a lot more as this credit crunch evolves. I am not sure how it will end, but, like the infamous Chrysler bail-out that culminated the failed presidency of Jimmy Carter, I expect that President Bush will have to deal with the government take-over of Fannie Mae and Freddie Mac.
I don't always get it right, and, especially in this case, I became more constructive earlier this year (and remain so) a bit early. In fact, I purchased some FNM in the 20s earlier this year when I mistakenly assumed that their brighter future (higher market share) would come to pass, neglecting to envision that the fallacy of "implicit guaranty" would become unraveled beforehand (more below). I was sucked in by my view of them as "part of the solution". As I type, the details aren't yet fully known, but it is apparent that the Treasury will imminently announce a plan to "finalize its GSE back-stop". It appears that FNM and FRE will enter conservatorship, implying government control of their operations. It also appears that the government will take an active role, including financial support, to work through the challenges.
It is clear that the government's plan will most likely significantly dilute current shareholders. I have been following the GSEs closely my entire professional career (since 1986), and I can't tell you whether that means FNM or FRE will trade at 1 or 10 after the details become available. Even with the details, it will be tough to determine the value of the equity, but without them it is impossible. If the plan is perceived as feasible, it could ignite a massive rally in the market. If it is viewed as flawed, it could create a crisis of confidence unlike any that this country has seen in modern history. I think the former, but am prepared to deal with the latter if necessary.
Why is this such a big deal? The GSEs are the end of the proverbial line. The housing problems, which have been brewing for much longer than analysts and pundits generally seem to accept, surfaced initially with the demise of some unheard of "sub-prime" lenders. The market disregarded the significance at the time, writing off the problems to a small subset of the market. As 2007 progressed, the depth of the problems became more obvious, and we have now seen the actual or virtual elimination of all of the major players who had a significant touch on the mortgage finance market. Originator Countrywide (conforming and jumbo), investor/market-maker Bear, Stearns, guarantor of non-agency mortgages ABK and MBI, Alt-A/non-conforming specialist IndyMac, and, of course, the big daddies (or is it mamas?), Fannie and Freddie. If we can address these issues and get the mortgage market functioning more normally, we can move on. If not, the downward spiral will continue.
The GSEs ARE the mortgage market. The long partnership between government and the private sector has enabled a transformation in the financial world. In the olden days, if you wanted a mortgage, you went to your local bank. That bank would hold the mortgage as an investment. The "implicit guaranty" has allowed the mortgage market to standardize, where banks now originate loans per standards and the assets can then be pooled and sold either to banks or other types of investors.
The GSEs retained a significant portfolio of mortgage investments as well. For borrowers, the end result has been lower interest rates than would have been available otherwise. The cost? Absolutely nothing - until now. The government used its "implicit guaranty" to enable lower rates by removing credit risk. By partnering and not having an "explicit guaranty", it avoided reflecting this in its balance sheet or its "income statement" - the annual budget. Now that the whole scheme has become unraveled and the government can't afford to stiff banks and foreign entities, everyone wants to point fingers and express moral outrage. The simple analysis is actually the correct one - the government failed in its regulatory oversight.
I have been almost amused by the cries of outrage and the pleas that the "taxpayer" shouldn't shoulder the burden of fixing this problem. Very few of these folks have complained about the relationship between the GSEs and government over the past few decades, but suddenly they find it wrong that this was the system. While they don't want to "pay" for it, they simultaneously fail to credit it for keeping mortgage rates lower than they might have been otherwise. They also don't seem to mind that they are allowed to deduct mortgage interest (subsidized by renters) or to exempt capital gains from their taxable income when they sell their homes.
No matter how one looks at it, we are in this as a society. For whatever reason, home ownership has been viewed as "good". The mortgage deduction, the capital gains break and the GSE model all share this goal. The poor regulation of these entities has left them facing highly uncertain future cashflows.
No one knows how much of a hit the GSEs will take on their portfolios and their guarantees. As a result, no one is in a rush to lend them money. It is very possible that the losses will be far less than many expect, or they could be greater. It really depends upon what happens to housing prices. The worse it gets, the worse it gets. Pretty simple. What is clear, though, is that the recent lack of mortgage credit available isn't helping the situation. Clearly, we need to get the GSEs through this period of tough access to capital, which is what I think the plan is all about. Mortgage rates have increased over the past year - this isn't helping!
For those who think that the common equity holders should be "wiped out", I question that sentiment. As one can see, there aren't too many equity holders who haven't already been de facto wiped out. FNM hadn't done anything for seven years until it started to plunge last year, and it's value is a mere fraction of what it was even 15 years ago. If the plan is so punitive to shareholders that it doesn't allow them any participation in the future of the company, I believe that the government will never be able to partner with the private sector. How else are we going to get a better Post Office?
click to enlarge
Yes, there have been a lot of people over the years who profited greatly from this partnership, perhaps even some current executives. Directing anger towards the shareholders, though, makes little sense. There isn't a single political party to blame - they both are culpable. Alan Greenspan deserves some of the blame as well. One can have a debate about whether or not it ever made sense to have this scheme of the federal government subsidizing housing (yet again) by avoiding the proper on balance sheet accounting, but that won't fix the current problems.
We have two giant, historically mismanaged and underregulated, vital lynchpins to our economy. We need to get them capital in the least costly and quickest fashion that we can, reestablish a normal mortgage market and then deal with a longer-term vision. For those who don't won't to do this but still want to deduct their mortgage interest, you are hypocrites. Forget about the capital gains benefit, as that ain't happening. I can assure you that without restoration of the mortgage market, we will have falling home prices, job loss and an even bigger mess to address. On the other hand, by addressing the issue, we may be setting in place the path for an economic recovery.
Disclosure: Long FNM