Fannie & Freddie Are Here to Stay

Includes: FMCC, FNMA
by: Stockerati

A lesson I learned from the Bear Stearns (NYSE:BSC) fallout was that if you get into a stock when it hits rock-bottom, your investment can only go up. While I was a little late with the Bear Stearns opportunity (when it briefly traded at $2 and change); I see a potential opportunity for me (and like minded investors) to make good on the now notorious: Freddie and Fannie.

Federal National Mortgage Association, a.k.a. Fannie Mae (FNM), and the Federal Home Mortgage Corporation a.k.a. Freddie Mac (FRE), have operated as a duopoly since 1968 as government sponsored enterprises [GSEs]. In common speak it means that while they are privately owned and operated by shareholders. they are protected financially by the Federal Government. The protection includes access to a line of credit through the U.S. Treasury, exemption from state and local income taxes and exemption from SEC oversight. As of today, Fannie Mae and Freddie Mac control about 90 percent of the US secondary mortgage market.

With $5 trillion in mortgage assets, Fannie Mae and Freddie Mac are dominant players in the home-lending market. But both are also the latest casualties of the sub-prime mortgage crisis. Continuing drops in both companies’ stock prices last week raised significant concerns over their solvency, prompting the White House, Federal Reserve and the Treasury to find a way to shore them up.

Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder owned companies. Their support for the housing market is particularly important as we work through the current housing correction. They are quintessential to the American economy as reinforced by the recently passed housing bill. The Feds have offered to bail out the two companies by lending them at a 2.25% rate. Under a provision put into the bill late in its development at the administration’s urging, Fannie and Freddie could draw on a temporary line of U.S. Treasury credit or the government could buy shares in them, if they ran into trouble.

Their combined debt is equal to 46% of the current US national debt. It is this combination of rapid growth and over leveraging that has lead to the current concerns with regards to the financial practices of these GSEs. Fannie Mae and Freddie Mac are the only two Fortune 500 companies which get exemption from having to inform the public about any financial difficulties that they may be facing. In the event that there was some sort of financial collapse within either of these companies, U.S. taxpayers could be held responsible for hundreds of billions of dollars in outstanding debts.

The US Treasury plans to inject as much as $25bn of fresh capital into beleaguered mortgage firms Fannie Mae and Freddie Mac. The amount of money involved with any US government “bail out” of Fannie Mae and Freddie Mac is just so enormous and the financial impact of losing the home mortgage loan guarantees so profound that the AAA credit rating of the US government itself could be called into question.

The cash injection is one of several plans being considered by US Treasury Secretary Hank Paulson as he looks to instill confidence in the country’s ailing mortgage market. On Sunday July 13, 2008 the US Fed and the Treasury Department asked Congress to temporarily increase lines of credit to Fannie Mae and Freddy Mac and to let the government buy their stock. On July 18, 2008, Freddie Mac filed with the Securities and Exchange Commission [SEC] in a step toward issuing common stock. This move would create the potential for more capital to be raised to support the enterprise. There’s an outside chance that this move  could also dilute the value of its stock for current investors, but it’s too early to tell.

If Fannie and Freddie lose shareholder and investor confidence and are unable to sell on debt, they will have to stop buying mortgages, sending the interest rates charged to home buyers soaring, not what is planned for at least the next 6 months (Read my earlier post on Interest rates versus inflation to understand why I believe that to be the case). This in turn, would make it more expensive and difficult, if not impossible, for home buyers to obtain credit, thereby freezing the United States housing market.

Interestingly, both McCain and Obama have Fannie Mae and Freddie Mac advocates as advisers or on their campaign staffs, Additionally, the difficulties of Freddie and Fannie, if not fixed, could potentially damage economies worldwide as their securities are held by numerous overseas financial institutions, central banks and investors.

Given the above, I feel these institutions are too big to be allowed to fail—not only because they are GSEs but the government has always had an implicit responsibility to regulate them (which they unfortunately didn’t). Therefore, they cannot and will not be allowed to fail.

Both Freddie and Fannie are stabilizing at newer levels after hitting rock-bottom in recent weeks. They are both trading in the $7-$11 range, a fraction of their 52 week highs but between 50-100% above their rock-bottom prices. Until the fuzziness clears out, it’s an arduous and impossible task to peg their future value. However, they represent the real-estate market which in turn is fueled by the dream of every American and therefore they are in a lot of ways the backbone of the American economy.

Their future M.O. will be scrutinized and regulated and the way they do their business may and will change for sure. But they are here to stay and aren’t going anywhere but up from here. They will make a good addition to my portfolio—a decision more governed by extraneous factors & raw politics and not by real numbers—a first for me. What do you say?