Fannie & Freddie: Don't Say You Weren't Warned

It looks like Fannie Mae's and Freddie Mac's tenure as public companies is drawing to a close. Yves Smith at Naked Capitalism (one of my daily must-reads) has put together a helpful overview of the latest (breaking) developments in "NY Times: Fannie, Freddie Nationalization (aka Conservatorship) Imminent":

Guess the powers that be were unwilling to risk playing chicken with the markets and losing.

So much for the theory espoused by some that the government couldn't put the GSEs into custodianship absent a breaching of statutory minimums (technically, by being insolvent under the "fair asset" valuation method, Freddie is already on plenty thin ice). Nevertheless, this is quite a Friday night bombshell, particularly since the plan, as the Times appears to have garnered a few more details beyond the initial reports, is not minimalist (say an preferred equity purchase with no management changes). Conservatorship officially makes the GSEs wards of the state.

However, the rumors have not yet converged on the shape of the plan, The New York Times says that not only would the existing chiefs and likely the board will be given the heave-ho, but that the preferred shareholders would suffer as well as the common equity holders (note the details of the recapitaliztion were not reported). That was surprising and may not be correct. Most observers had assumed that preferred shareholders would be spared, since many banks hold significant slugs of Freddie and Fannie preferred, and a big writedown would be a direct hit to the bottom line.

A report from the Washington Post gives a skeletal outline of the financial and legal arrangement; the Times has a more background (note the post has been updated to include the WaPo information and reflect the divergence of reports). Per the Times, a formal announcement is expected before the Asian markets open Sunday.

From the Washington Post:

The government has formulated a plan to put troubled mortgage giants Fannie Mae and Freddie Mac under federal control, dismiss their top executives, and use government funds to prop them up, government officials told the two companies yesterday, according to sources familiar with the conversations.

Under the plan, the federal government would place the firms in a legal state known as conservatorship, the sources said. The value of the company's common stock would be diluted but not wiped out while the holdings of other securities, including company debt and preferred shares, would be protected by the government.

Instead of giving each company a big capital infusion up front, the government plans to make quarterly infusions as the companies' losses warrant, the sources said. This would be an attempt to minimize the initial cost of the rescue.

From the New York Times:

Senior officials from the Bush administration and the Federal Reserve on Friday informed top executives of Fannie Mae and Freddie Mac, the mortgage finance giants, that the government was preparing to seize the two companies and place them in a conservatorship, officials and company executives briefed on the discussions said.

The plan, effectively a government bailout, was outlined in separate meetings that the chief executives were summoned to attend on Friday at the office of the companies’ new regulator. The executives were told that, under the plan, they and their boards would be replaced, shareholders would be virtually wiped out, but the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

It is not possible to calculate the cost of any government bailout, but the huge potential liabilities of the companies could cost taxpayers tens of billions of dollars and make any rescue among the largest in the nation’s history....

Under a conservatorship, the remaining common and preferred shares of Fannie and Freddie would be worth little, and any losses on mortgages they own or guarantee could be paid by taxpayers. A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets.

The executives were told that the government had been planning to announce the decision as early as Sunday, before the Asian markets reopen, the officials said...

Officials said the participants at the meetings included Mr. Paulson, Ben S. Bernanke, the chairman of the Fed, and James Lockhart, the head of both the old and new agency that regulates the companies. The companies were represented by Daniel H. Mudd, the chief executive of Fannie Mae, and Richard F. Syron, chief executive of Freddie Mac. Also participating was H. Rodgin Cohen, the chairman of the law firm, Sullivan & Cromwell, who was representing Fannie.

Officials and executives briefed on the meetings said that Mr. Mudd and Mr. Syron were told that they would have to leave the companies.....

The meetings reflected the reality that senior administration officials did not believe they could wait for some kind of financial tipping point, as happened with Bear Stearns....

With the possible removal of the top management and the board, it is no longer clear who would appoint new management.

Some interesting tidbits from Bloomberg:

The meetings come a month after Paulson hired Morgan Stanley to advise on any use of taxpayer funds to recapitalize Fannie and Freddie, and before the FHFA [Federal Housing Finance Agency] releases an assessment of their capital....

Mudd and Syron must approve of any government intervention under the law, unless the FHFA declares that either firm has insufficient capital. The legislation gave the Treasury the power through the end of next year to extend unlimited credit to or make equity purchases in the firms.

Given that this meeting with Mudd and Syron appears to have been a one-way communication. it seems likely that there was something due to be released that either gave James Lockhart, the head of FHFA, the smoking gun to intervene, or was sufficiently troubling to run the risk of an adverse market reaction, which would at a minimum raise the GSE's cost of funding, which is already high enough to create worries that it might interfere with fulfilling their charter.

 

Update 11:20 PM. This comes via e-mail from James Bianco of Arbor Research:

As of this writing (Friday night, 10:14), it appears no one has a clue as to how the Fannie/Freddie Government bailout is going to work. I guess will have to wait for the now common Sunday night/Monday morning press releases to save the financial system from ruin....

If you’re are keeping score at home we had Sunday night/Monday morning “save the world” press releases in August 2007 (cut of the discount rate), December 2007 (TAF), January 2008 (ease 75 bps), March 2008 (Bear) and July 2008 (first Fannie/Freddie rescue) and now September. Anyone want to believe this is the last one (which will be the sixth in 14 months) will be the one that finally works and saves the world?

Bianco went further than we did above, and listed what the Times, Wall Street Journal. WaPo, Financial Times, and Bloomberg had to say. No convergence. Nada (looking at Bloomberg, it quoted WaPo on some matters and cited earlier "analyst opinion').

It's possible that inconsistent information is being leaked deliberately. The first time I saw that happen on a deal I was close to was on Goldman's acquisition of commodities trading firm J. Aron. It may be that the powers that be assume they cannot prevent information getting out, and prefer to muddy the waters until an announcement is ready to go.

 

Update 12:05 AM. A key bit from the Wall Street Journal:

The meetings Friday were in part aimed at getting Messrs. Mudd and Syron to agree to the plan, though their approval was not necessary, these people said.

Of course, anyone who has read my book, Financial Armageddon (which was first published in March 2007, when all was bliss), or who has paid even scant attention to the many posts I have published at Financial Armageddon on the subject of GSEs since December 2006 won't be surprised.

For those who haven't been paying attention (especially those "smart money" types who have continued to hold or have been buying the shares of the two companies over the past year or so), here is a brief sampling of what you may have missed:

Introduction to Financial Armageddon: Protecting Your Future From Four Impending Catastrophes:

Few paid attention to warnings from Eric Breval, the head of the $15.5 billion Swiss state pension fund, in a November 2005 Bloomberg report. He discussed plans to shift assets away from the United States and referred to the financial “time bomb” that the nation’s largest mortgage lenders, Fannie Mae and Freddie Mac, were sitting on. The same held true in April 2006, when Citigroup vice chairman William Rhodes told the Wall Street Journal, “We are in a situation similar to that which existed in the spring of 1997, when threats existed to market stability and a lot of people didn’t want to see it.”

"Nightmare on GSE Street":

Astute observers have long suspected that government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac represent a major threat to the U.S. financial system (in fact, I discuss this issue in Chapter 3 of Financial Armageddon).

Of course, when I say "astute," I'm not talking about the highly-paid Wall Street analysts who cover these stocks or the institutional investors who still own millions of shares of either company, because they are basically clueless. I mean people who actually know how to think and who understand such rudimentary concepts as moral hazard and the unintended consequences of government actions.

In "Is Fannie Mae the Next Government Bailout?" Jonathan R. Laing of Barron's lays out out the bear case for this particular disaster-in-the-making, though his analysis does fall short in one respect. By the time any bailout does come about (assuming it does), the financial system will have been shredded like Freddy Kreuger's unwitting victims in the Nightmare on Elm Street film series.

"Freddie Mac Freak Show":

I've know I've spent a bit of time writing about government-sponsored enterprises lately, but yesterday's reaction to Freddie Mac's results was truly a sight to behold.

In my view, the fund managers who drove the stock higher should hand in their notices at the first opportunity, because they clearly have lost touch with reality.

Even if -- and I don't rule out this possibility -- the government eventually steps in and rescues either one or both of them, the odds that shareholders will survive unscathed must surely be close to nil.

Anyway, in "Freddie Mac Posts Quarterly Loss Tempered by Accounting Techniques," Charles Duhigg of the New York Times reports on yesterday's freak show...

"Ignorance Is Bliss?":

There seems to be no limit to the ignorance of some investors.

Even though a collapsing housing market, the prospect of a nasty, consumer-led recession, and razor-thin capital cushions make it clear that the outlook for the country's largest mortgage lenders is dicey at best, investors have decided they know better and have been bottom-fishing in the shares of Fannie Mae and Freddie Mac.

Meanwhile, foreign investors, who are often clueless about such risks until they are suddenly blindsided with the bad news they should have been expecting, have been piling into the debt of these two government-sponsored enterprises.

Still, it should be fun to watch when an ever-so-predictable reality, which articles like the following from Reuters, "Fannie, Freddie Regulator Sees More Risk Ahead," are already alluding to, eventually unfolds and these people lose their shirts.