I read with interest Kurt Dew's SA article, Fannie And Freddie: In Or Out, published on Dec. 14th, in response to a Gretchen Morgenson column published on Dec. 12th in the New York Times, Business Day. I lauded him for a well-written piece but said I had been working on a similar article with the opposite conclusion. I was not alone as at least 90% of the comments disagreed with his thesis, some in not so kind words which I feel is unfortunate. We should all feel free to state our opinions without ridicule, even if some feel they are wrong. Some of those comments were filled with emotion and that is the worst way to make an investment decision.
But this situation, with two stocks of great importance to our economy, yet valued at less than $2 a share, has major ramifications for the entire U.S. economy. Sadly, I feel that the Obama administration, in a grab for more revenues while under siege from a contentious Congress, is wrong for several reasons: fairness, as no other institution has been treated as harshly and many received far more benefits; this is a short-term solution that will haunt us for decades while enriching the banks as they make a mortgage grab, but at below market prices for the assets; and an implosion in the mortgage market which would hurt the entire economy if the banks are again placed in a situation where their capital is impaired - a situation I feel is very likely and sooner than we think.
Looking back to late 2008 when Henry Paulson was toting that 'bazooka in his pocket' (a vivid but poor analogy), Bear Stearns had nearly imploded until the New York Fed engineered a bailout by JPMorgan Chase (NYSE:JPM) for a pittance of its true worth. Furthermore, the crisis was exacerbated by 'naked' short selling of bank and brokerage stock while the SEC sat on its hands under Chairman Christopher Cox. Lehman Brothers was allowed to fail when it was the one that should have been saved - somehow - due to its huge mortgage-backed securities operation (MBS). Then, there was the aid to other banks and firms… declaring Merrill Lynch, Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS) as banks so that they could use the Fed's financing facility when they were, and remain, anything but banks (Merrill has since been acquired by Bank of America (NYSE:BAC), which tried to back out of the deal but was forced to go through with it, and unlike the ill-conceived buyout of Countrywide Financial with virtually no due diligence, it is arguably, through its investment management operations, BAC's greatest asset.)
This background is crucial to understanding why Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) were in far better shape than the major banks. Theirs was a liquidity problem, not a credit problem. But in the panic at the depths of the crisis, Congress acted in a very Kafkaesque manner, doling out credit to some, including AIG Financial (NYSE:AIG) which was the source of the major problems in the credit default swap sector, while letting CIT Financial nearly go bust as they believed it had a huge mismatch of assets and liabilities, despite it being in the factoring business, and this pulled the rug out from the majority of small businesses when they needed it most. Eventually, but not after worsening conditions, they were allowed in.
Then the Treasury made available to the banks… the cause of the entire mess… TALF and TARP funds, and even these they abused as they issued government guaranteed bonds, put the offerings together late at night, and without a 'bonafide public offering', sold the bonds mainly to hedge funds so that when the natural buyers wanted to buy the next morning, they were trading at huge premiums. I never saw one of these deals that I, or my fellow advisors, could get in on at the original selling price
Since their inception, the GSEs have been lightning rods for criticism in political circles, generally by Republicans, but both were 'equal opportunity contributors': in the House to Democrats, but to Republicans in the Senate, especially committee chairmen. Historically, they went so far as to open an office in the chairman's districts. Despite this, their lending side knew what they were doing, while the administration-appointed cronies were the public face.
There is nothing new about this. When I first entered banking in 1972, they had their critics, but by the 'moral obligation', it was assumed they would never be allowed to default, although this issue appeared every few years. But they also each had a $1 billion line of credit with the Federal Reserve, which instilled a lot of confidence and I never saw a liquidity problem throughout my career.
Furthermore, both were late in getting into the subprime game, yet had higher quality loans than the deals put together by Wall Street and subsequently had a significantly lower default rate.
Incongruously, for a Democrat president, it is the administration that has been the thorn in the GSEs' side. They have been held to stricter ratios than the banks, and despite their profitability (which did decline sharply this year), the government has conducted a money-grab that even many members of Congress don't approve of, for despite its criticisms, every President has endorsed them, including George W. Bush in his first term who gave a rousing endorsement of their program to put more Americans into their own homes.
Both FNMA and FMCC have rebuilt their earnings in exactly the same way as the major banks in a low interest environment: recapturing the enormous increases in loan loss reserves that were forced on them as with the banks. But the issue now is the $74 billion tax-loss carryforward that is coming into play so they are being required to pay that entire sum in cash… something none of the banks has been made to do, and there is a growing view that it is an illegal move, just as they were prohibited from taking action against the banks for the falsified loans that were sold to them. Try explaining that, because this writer cannot. There is at least one court case that could, and should, reverse the government's actions.
In conjunction with this, an idea has come up to dismantle them and sell the assets to the banks… the big banks which would undoubtedly only do this at fire sale prices. But once that is done, the entire housing market will be at the mercy of the banks, which do not like to make mortgages in periods of high interest rates which is why mortgage-backed securities originated in the first place. Even now, they are making the loans, then selling them to the GSEs while retaining the 50 basis point servicing fee. It doesn't take a genius to realize that by churning the loan portfolio in an era of 3-4% mortgages, you can generate more revenue by not keeping them on the books while still servicing them. One shudders to think what would happen in a high interest rate environment; in fact, we know exactly what the banks will do from historical experience.
Lastly, according to Senator Elizabeth Warren, the banks are holding $10 trillion of derivatives on their books. The bankers quickly said that is the 'notional value', not the amount that is actually at risk. But we have been here before. These derivatives are not conforming so once you own one and want out, it requires an offsetting trade, which piles up the contracts. This would not have been the case if Greenspan, Rubin and Summers had supported CFTC Chairman Brooksley Born when she suggested standardizing them so they could be traded on an exchange. The crisis would never have occurred if she had prevailed… furthermore, that was one of the original provisions of Dodd-Frank that the banking lobby successfully had removed.
I believe it is clear that the GSEs have done everything that has been asked of them, and significantly more than the banks which made those risky mortgages, yet it isn't enough to satisfy the government, and in an economy that is so dependent on the housing sector, removing these two clearing houses is not an acceptable solution. It is imperative that the actions taken be reversed in order to ensure a healthy housing sector.
According to today's American Banker, Rachel Witkowski reported that yesterday, the Office of the Comptroller of the Currency issued details of a notice sent to the banks that they must submit a "recovery plan" of how they would survive a crisis. Would they even dare to include in that plan a statement that they would continue to support the mortgage market? If so, it would be an unmitigated lie.
Even as this article is being written, the Federal Housing Administration has come under fire, according to an article by Scott Olson. When will the madness end?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.