The Spanking of Fannie (& Freddie)

The shares of the two giant Government Sponsored Enterprises (GSEs), Fannie Mae (FNM - Snapshot Report) and Freddie Mac (FRE - Analyst Report) have been in an absolute freefall over the past week.  We have long warned that the attempts to put the burden of the mortgage crisis on the GSEs was misguided and would eventually put the two of them in peril. 

However, since the two have a special relationship with the government, and as of a few months ago appeared to be relatively healthy, the temptation just proved to be too great.  These moves included things like the expansion of the cap on the size of the mortgages the two could buy, and encouraging them to insure more mortgaged backed paper than they already did.  Now the market is convinced that they are both severely undercapitalized, despite assurances from regulators that they still meet the required capital levels. 

If mark-to-myth accounting is used, they do.  If mark-to-market accounting is used, it seems very clear that they are very undercapitalized.  Even though the underwriting standards at the GSEs were generally better than for the private label mortgage backed securities that have already blown up, in retrospect they have proved to be too loose.  In part this was because FNM and FRE relied on private mortgage insurance from firms like PMI Group (PMI - Analyst Report) and MGIC (MTG - Analyst Report) which now appear to be on the brink of insolvency themselves. 

The GSEs were always far more leveraged than commercial or even investment banks.  They could get away with extraordinary levels of leverage because of an implied guarantee from the government.  

The collapse of the housing market has brought down the values of houses across the country.  It has hit the value of houses with imprudently underwritten mortgages, prudently written mortgages, and indeed the value of houses with no mortgage on them at all.  As people become farther and farther underwater on their houses, they become that much more likely to default on them. 

The fact that wages are not rising anywhere close as fast as the cost of living, especially for necessities like food and energy, has not helped matters.  Similarly, the loss of a half million jobs or so since the start of the year is not helping homeowners cash flow.  As delinquencies and foreclosures rise, the GSE's start to lose money, after all they either hold these mortgages in their own portfolios, or they guarantee the value of the mortgages that back privately held mortgage-backed securities.

Leverage is of course a ratio, with Assets in the numerator and Equity in the denominator.  Losses directly hit retained earnings, which is the biggest part of equity.  Thus as equity falls, leverage rises, and Fannie and Freddie are already too leveraged to start with.  Either the equity has to be replaced, or assets have to fall -- simple 4th grade arithmetic. 

Well, with Freddie shares trading for about $5 a share, and Fannie's around $8, replacing the equity will be massively dilutive.  Think pouring a shot of Dewar's into Lake Michigan and calling it scotch and water.  Existing shareholders would be effectively wiped out. 

What about reducing assets?  That would be better for the shareholders of Fannie and Freddie, but it would be close to the end of the world for the housing market.  Right now, just about the only mortgages being made are those that can be backed by the GSEs.  If they have to stop buying mortgages or guaranteeing them, then the entire mortgage finance system in the country comes to a complete and total stop.  If you think the housing market looks bad now, just wait until that happens. 

While the shareholders of the two firms being wiped out would not be a good thing, it would sure beat the failure of either as an institution.  That simply will not be allowed to happen, regardless of what Hank Paulson says.  However, a government bailout of either would be extremely expensive.  If the government has to recapitalize them, it should follow the example of the Chrysler bailout of the 1980's where the government got warrants and actually made a profit on the bailout. 

If the Federal government were to buy new stock, it would amount to a nationalization of the mortgage industry.  That's not something one expects from a GOP administration, but they might have no choice but to do so.

Read the full analyst report on FRE.

Read the full analyst report on PMI.

Read the full analyst report on MTG.