On Sunday, U.S. federal regulators outlined their takeover plans of the combined $5 trillion giants Fannie Mae (FNM) and Freddie Mac (FRE). The Treasury Department in conjunction with the Federal Housing Finance Agency [FHFA] will use the full faith of the U.S. government to back the two institutions which have been at the core of the illusion of prosperity created by the inflation of real estate.
Reports of overstated equity, upcoming write-downs that exceed the government's estimates and capital market's reluctance to fund Freddie and Fannie, prompted action this weekend. Clearly the rest of the banking system can be assumed to be in the same boat with overstated assets and equity values. In addition, the idea is that nobody has a clue of the value of the falling house of cards called banks
The two companies are now placed in "conservatorship" (in lieu of "receivership") overseen by the FHFA will be run by the government until they are on stronger footing (i.e. five to ten years). Two veterans will replace the outgoing CEOs. Herb Allison ex-Chairman of TIAA-CREF and ex-Merrill will run Fannie, and David Moffett ex-U.S. Bancorp and ex-Carlyle group will run Freddie.
The largesse of the government will provide as much as $200 billion of new capital, and new credit lines. The Treasury plans to buy an unspecified amount of mortgage-backed securities in an attempt to lower mortgage interest costs for homeowners and in addition it is also setting up back up facilities for the 12 Federal Home Loan Banks which provide advances to its 8,000 members.
Dividends on both common and preferred shares will be eliminated, saving about $2 billion per year. And finally the Treasury is acquiring $1 billion of senior preferred stock from each company that include a 10% dividend yield and the right to purchase 79.9% of the common shares at a nominal price. In other words, the common shares are wiped out and preferred shares may follow depending on the level of losses over time. The government took a hard approach to common and preferred shares.
The plan also includes limiting the size of the giants to a maximum of $850 billion as of the end of 2009 (Fannie's own balance sheet size is about $758 billion and Freddie's is $798 billion). Afterwards, the Treasury intends to reduce the portfolio of each by 10% per annum until each reaches $250 billion. It seems as if in the short run there will be an expansion of the portfolios to support housing.
Let's take a look at the upcoming mortgage tsunami, before providing an opinion on the plan. New foreclosure proceedings reached 490,000 in Q2 taking total foreclosures to a record of 1.2 million homes, representing 2.8% of all outstanding loans or double from a year ago. Delinquency rates for mortgages that have missed at least one payment are also in record territory -- that is a staggering 2.9 million delinquent mortgages! Further mortgage losses are unavoidable.
While this "nationalization" will provide a short term relief, the plan at best may only reduce the pace of the price slide in housing in the U.S. while the credit problem is global and continues. Since Mr. Paulson received authority from Congress to do whatever he pleased to support Freddie and Fannie, it has been an anticipated action, hence it has already been discounted by the markets for the most part. It is unlikely that we will see a sustained equity rally as it questions the situation of all other financials.
We are bothered by the government's attempt to stop the credit bubble from deflating and trying to support house prices in a highly politically motivated bail out. The moral hazard of the government's actions will be felt by future generations. Bond vigilantes should be put on alert as a borrower set to keep issuing paper in large amounts should be punished with higher rates -- maybe offsetting Sunday's actions. The U.S. is behaving like an emerging market of the 1980s or 1990s and moving faster than Chavez!
Stock position: None.
