Ugh. I’m still not home yet, but after my recent 48-hour news blackout, the news on Fannie and Freddie is pretty amazing. Now, I would not be so certain that an interpretation of SFAS 140 would force Fannie or Freddie to raise capital — GAAP accounting often has little to do with regulatory capital rules. Only if OFHEO decides to mimic the treatment in GAAP would it force capital-raising, absent any net worth covenants on their debt that might be poorly written.
All that said, the problems with Fannie and Freddie are not primarily accounting-driven, but are being driven by diminishing housing prices, which erodes their margin of safety on their lending and loan guarantees, and diminishes the value of the mortgage insurance that they rely on for some of their business. Writedowns from these items are what hurt. It is likely that Fannie and Freddie need to raise capital, but the great questions are how much is needed, and how much can the market stomach?
At times like this, I run through my pecking order of the “financing methods of last resort.”
- Have you maxed out trust preferred obligations? Other subordinated debt?
- Have you maxed out preferred stock?
- Have you issued convertible debt to monetize volatility?
- Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
- Have you sounded out investors in your corporate bonds about debt-for equity swaps?
- And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?
All of these financing methods carry a cost. (And, as with most situations like this — if it were done, best it should be done quickly. Delay usually means that cost of financing rises.) Most of the cost is dilution to existing shareholders, whether common or preferred. The debt guarantee, or investment by the government has costs for the US taxpayer, which I would rather not see.
Clearly, Fannie and Freddie have room to raise more capital, but the room is not unlimited. As the Financial Guarantors found, when your stock price gets too low, the jig is up. You can only raise so much capital relative to the size of your current market capitalization before the market chokes. After all, most capital raising requires a discount to current price levels, and somehow the diluted value of the equity needs to represent a premium price where new capital gets put in.
In short: it’s tough to get new investors to pay for past losses. Capitalize a new company? Could be done, and has already happened with the Financial Guarantors, which has largely sealed the fate of the tarnished incumbents. That said, why would the US government want a competitor to Fannie or Freddie, aside from GNMA?
As for the US Government, perhaps this all waits for a new President and Congress to act. Personally, I think that any help extended to Fannie or Freddie should have strings attached. Investments, or debt guarantees should allow the US government to profit if things turn around. Other things to explore: only guaranteeing new liabilities, or, expanding the role of GNMA, which is a full-faith-and-credit of the US Government lender.
The one thing I don’t want to see is a bailout that benefits the shareholders of Fannie or Freddie. They have long had private profits with many public subsidies for years. Now it is time for the shareholders to bear the losses; let public money only step in to keep senior obligations whole, if it steps in at all.
(Note: these are my private opinions, and not those of my employer.)
Amen, David. Well-articulated and, IMHO, spot on. Taxpayers have gotten hosed for far too long subsidizing private sector profits for these quasi-governmental entities. Enough is enough!
Roger
i don’t disagree with any of your analysis, but it seems to me that you should be careful what you wish for.
the GSE’s have funded $4T of mortgages, that’s roughly 40% of all debt outstanding, at very attractive long-term interest rates (e.g., 6% wtd average coupon across the entire MBS stack). the liquidity they bring to the market results in demonstrably lower rates for a large number of households across the country.
right now, a lot of their capital needs are due to the fact that policy makers want them to grow their MBS business to support the housing market, and grow their retained portfolios in order to relieve some of the liquidity pressures facing the banking sector. these new business activities, i should point out, are to some extent, discretionary. after all, it wasn’t too long ago that the bush admin wanted the companies to shrink and become a smaller part of the market.
if the companies were to reduce volumes and/or de-lever their balance sheet, there would only be one way to ration access to credit: price. some would argue that this is the right thing to do during this volatile period. it’s what every single bank out there – all of whom have explicit guarantees through the FHLB and the FDIC – is doing right now. but, it would have a steep cost for marginal borrwers, who would see their mortgage rate rise to 9%, given the liquidity challenges facing the global financial system.
then there’s the question of those “private sector profits” that you talk about the companies earning. did you ever think for a minute who earns those profits? it’s primarily the excess spread earned by the bondholders of agency debt & MBS. the residual dividends & capital appreciation earned by the shareholders is a much smaller amount relative to what the bond community siphons off.
and who exactly holds agency debt and MBS? diversified bond & money market mutual funds owned by middle america. it’s not privateers, looking to make a buck of the government. it’s pensioners and savers from around the country looking for a decent investment return in an area of excess financial liquidity.
so let me get this straight. in the name of ideological purity, you’re arguing that the government should first screw US savers by forcing a big haircut on agency debt & MBS holders. you’re also implying that the govt should then screw US home buyers through the higher mortgage rates that would result if the US govt treated fannie mae the same way the russians treated yukos?
that seems like very silly public policy to me. it only makes sense if you think prime, conforming delinquencies are headed to the stratosphere.
i’d be willing to bet a substantial amount of coin that very few folks on this blog could provide a detailed, analytical estimate of the level of 90 day delinquencies the companies would have to report before solvency became an legitimate issue.
Anonymous,
I might quibble with some or your arguments but the last paragraph was brilliant. We’re living in a mark to market fantasy land with no analysis of intrinsic value. Congratulations on pointing out the fallacy of most of the current wisdom.
Anonymous; thank you for sharing your well thought out views. Very insightful
The US savers are screwed already. Inflation is
likely over 10% now — interest rates should be
much higher than that, after taxes.
If the US congress used a regular credit card company they’d already have had their limit
lowered and be on 30%+ penalty rates.
Without Fed support of their debt the US treasury
is toast… With it the dollar is toast.
All this Fannie and Freddie stuff is just noise.
Great article, David. But I do disagree a bit with your comment that “They have long had private profits with many public subsidies for years. Now it is time for the shareholders to bear the losses”
The private profits from the subsidies have mainly gone to pay huge bonuses to management and generous salaries to other employees over the years. Any profits earned from dividends by long term shareholders have already been more than wiped out. The only shareholders that have benefitted are those that sold out several years ago or the short sellers.
George, anyone buying and holding indeed lost money. But guys like Buffett sold at opportune times and made a great deal. Those buying after he sold lost even more.
I guess I’m just trying to say that the equity should not get bailed out, given all the advantages that they had for years. But you are right, management walks off with a very good deal, even if the companies go into conservation.
Perhaps you have done so in previous posts and I missed them, but would you mind discussing how some of your current picks met your portfolio rules (or point me to the posts where you have done this). Thanks.