Things look grim for Fannie and Freddie, if market reaction is the benchmark.? The action in their stocks, preferred stocks, and subordinated debt was ugly on Monday.? Not only did you have the article in Barron’s, which made the case that the equity of the firms wasn’t worth much, but you had selling of their senior debt, and guaranteed MBS by foreign investors.? It may not be that Fannie and Freddie fail, but that they get recapitalized by the government in a way that massively dilutes the equity.? Or, going back to my old idea, they get nationalized and become part of GNMA.? The equity and preferred stock go out worthless, and the subordinated debt gets some sort of haircut (partial conversion to senior, plus an earn-out based off the losses the the government has to bear).? I’m not sure a bailout is inevitable, but the odds are rising.
Now, Fannie and Freddie have been through a lot in the last three weeks.? Freddie has changed servicer guidelines possibly in an effort to forestall current period losses.? They have also both reported huge losses:
Freddie:
- Credit losses are in their early phases.
- The Alt-A loans look horrid.
- Reported a large loss.? This brought them to a negative net worth for GAAP purposes, even counting in the questionable deferred tax asset.? With the negative fair value net worth, aside from the US government, who would pump in capital?? They want to raise 10 billion, but it is hard to raise more than your market cap — the dilution kills.
Fannie:
- Posts a big loss.? Stops buying Alt-A securities.
- Warns that July was worse than June.
- FBR suggests that Fannie needs $5-10 billion in capital, and the market behaves as if it is true.
Then there is the insult added to injury, as S&P downgrades the preferred stock and subordinated debt.
So, after all of this, we should steer clear of the securities of Fannie and Freddie?? Steer clear of the common and preferred stocks, yes.? Subordinated debt, I’m not sure, but when I’m not sure, I don’t take positions.
Now, the senior debt is another matter.? Spreads are very wide, and the possibility of nationalization is significant.? As Accrued Interest says:
The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.
I agree, and when I was a bond manager with a good thesis, I would ask which bonds offered me the best advantage.? This article ends with an idea that is practical to some institutional fixed income managers.? Both Fannie and Freddie have a small amount of long non-callable zero coupon bonds.? These bonds will have a significant rally in the case where the US government nationalizes them.? And, if the US government decides to let them slip into default, well, you are buying them at 20-35 cents on par value.? No way in an insolvency you get less than that.
The worst case scenario is that long interest rates rise generally, and the zero coupon bonds get killed.? Sophisticated managers could sell short Treasury zeroes to hedge.
PS — Now, as I wrote this, the estimable Jeff Miller put up a good post on the GSEs.? It is worth a read.
UPDATE — 11 AM 8/19
Manto’s comment below is correct, and I apologize.? Bonds originally issued as discount bonds have bankruptcy claims equal to their accreted value.? Bonds issued at par, that subsequently become discount bonds have a claim value of par.? Why did I make this mistake?? I improperly generalized from my experience trading discount bonds, and other structures (such as zero-to-full bonds created from bonds originally offered at par) where the claim would be par in bankruptcy.
Actually the claim for a zero coupon bond is not “par” in a CH 11. Its the accreted amount so you are not really buying at 20-35 cents of claim. Obviously an insolvency is highly unlikely but the analysis above is innaccurate.
Where is the line, then, because I know that discount bonds do generally get par claims in bankruptcy. Is it only zeroes that don’t get a par claim, or is there an interest threshold?
Help me, please: why does dilution “kill” for a [hypothetical] company that is under water, unable to meet current obligations, but that MIGHT be able to earn its way back to positive net worth and become profitable?
In other words, would you rather own 100% of a massive negative net worth, or 30% of a somewhat positive net worth?
I guess the “kill” argument is for owners who don’t yet realize that the company is a zombie / Dead Man Walking. But the damage (apparently! — no claim to security analysis here) was done steadily over the past years, and the management can be valuable to existing shareholders by bringing in others.
No? What am I missing?
Dilution kills because it forces the stock price down. Way down, if the dilution is huge.
It is relatively easy to do a secondary IPO if the new buyers think they are getting the net worth of the firm at a bargain price. Now imagine that the net worth is negative. What would a person pay to buy an asset that is under water? If is is not far under water, they might do it, but they would buy it for a nominal sum, and pump money into it after the purchase.
Deeply under water, no one will buy it. Read my post this evening for more details.
David, which kind of agency securities are more senior: agency-guaranteed mortgage-backed securities like pass-thrus and CMOs, or agency debt like a 5-year Fannie non-callable bond? As I look at the holdings of some of my mutual funds, I see both. Do both qualify under your description of “senior agency debt”? I’m guessing that the MBS guarantees have to be as senior as the “regular” bonds, otherwise it wouldn’t be possible for the GSEs to borrow and then guarantee the MBS — who would buy the MBS if the borrowing done to package it was senior to what you were buying?
They are equally senior. The loans guaranteed by FNM and FRE, whether packaged into passthroughs or CMOs, have the same level of creditworthiness as the senior unsubordinated notes issued by FNM and FRE.
Well, David, your post looks pretty prescient now – the FNMA/FHLMC equity holders are much worse off than the bond holders.
David, your answer that FNM & FRE passthrus have the same level of creditworthiness as the senior unsubordinated notes issued by FNM and FRE strikes me as unlikely. With the passthrus you have asset collateral as well as the full credit of FNM or FRE. While this is a moot point now, before we knew the gov’t would step in that asset would be worth something extra. The difference between a guaranty and a liability would provide the GSEs with some possibility of recovery against the originator of the mortgages under the reps and warranties of the purchase contract but I wouldn’t think they could use that argument against a purchaser of the passthru security.
I’m pretty certain that the collateral in the passthroughs and CMOs guaranteed by FNM and FRE is in the same place in the bankruptcy pecking order as the senior unsecured bonds. If that is wrong, then someone please correct me.
If they were subordinated, they would trade a lot wider. If they were senior, they would be a little tighter.
Mr. Merkel-
Kinabalu is correct: while the senior debt and the guarantees are pari passu as far as Frannie is concerned, the value of guaranteed MBS depends first on the value of the mortgage collateral (which is not a Frannie asset) and then on the Frannie guarantee; if the mortgages are good then the Frannie guarantee doesn’t even come into play. The value of the Frannie debt, on the other hand, depends only on what net assets are left at Frannie after the Treasury has finished pumping in its support.
Nonetheless, it may be notable that in bank receiverships (on which the Frannie receivership statute is modelled), the FDIC has taken the position (supported by some courts) that guarantees are contingent obligations that have no value — none — unless they were triggered and reduced to a claim before the receivership started. So in theory the FHFC as receiver might be able to repudiate the guarantees and pay no damages. But, as with the Frannie senior debt, such an approach is politically unthinkable.
The bottom line is that, if the Frannie senior debt and the guaranteed MBS are trading at about the same level, the market must be relying mostly on the Treasury support rather than on the value of the mortgage collateral. (Which sounds reasonable enough to me.)
It’s also worth noting that the FHFA as conservator or receiver, like the FDIC in a bank conservatorship or receivership, has lots of special powers (to repudiate contracts with limited damages, etc.) that are not available to an ordinary bankruptcy trustee. If the SEC had similar powers with respect to broker-dealers then this wouldn’t be such a nail-biting weekend.
Your original post was prescient, particularly with respect to the sub debt (the fact that Terasury chose a conservatorship which protected the sub debt does not change the fact that they could have done otherwise; and an eventual receivership that would effectively eliminate the sub debt is still a possibility), and identifying the long zeros was brilliant. Congratulations.
-JAFDC
I get it now. Thanks to JAFDC and Kinabalu for your help. Part of the reason for this blog is for me to learn too.
So, in a real crisis, the Federal backstop is the guarantee for MBS, as we have learned. Woe betide us if that ever fails.