Fannie & Freddie Got The Proper Treatment

On Monday, Sep 1, I posted on Fannie & Freddie:

"To give an example of how much GSEs are out there - last year China bought US66bn in GSEs debt and only US12bn in US Treasuries. Russia bought US34bn of GSEs debt and SOLD US22bn of US Treasuries. So, the Treasury and Fed have to quickly rescue Fannie & Freddie with absolutely no hiccups in congress. Anything less than that will see bond prices of GSEs debt falling like a rock and USD being pummeled by at least 10%-20%. While that is the "potential bad news", we should remember that Paulson and Bernanke also know that - hence its a postulation at best now, let no one go and do something silly like NOT fully rescuing Fannie & Freddie.You heard it here first, Fannie & Freddie will be nationalised."

http://malaysiafinance.blogspot.com/2008/09/chinese-warns-paulson-on-gses.html

Federal Housing Finance Agency Director James Lockhart will release details of the planned conservatorship of Fannie Mae and Freddie Mac (11am NYT Sunday). Lockhart's agency was created several weeks ago by Congress and is responsible for overseeing Fannie Mae and Freddie Mac, which own or guarantee more than US$5 trillion of U.S. mortgages. The companies have reported massive losses in recent months, in part because of their huge exposure to slumping housing market. They have faced repeated questions about the adequacy of their accounting and their stock prices have tumbled precipitously. Federal law allows the FHFA to take either or both company into conservatorship if certain criteria are met.

The recently enacted housing rescue law also gives Mr. Paulson a separate power to inject capital into either firm. The conservatorship is expected to include the departure of Fannie Mae chief executive officer Daniel Mudd and Freddie Mac chairman and chief executive officer Richard Syron, who took over at each company several years ago after separate accounting scandals. It is unclear how long a conservatorship might last or how much it might cost the U.S. government, though it will almost certainly extend into next year.

The longer-run future of the companies will be up to Congress, which created both of them to support the housing market, as well as the next administration. Treasury Secretary Henry Paulson briefed Sen. Barack Obama, the Democratic presidential nominee, on Friday and spoke on Saturday with Sen. John McCain, the Republican nominee. Fannie and Freddie are vital cogs in the U.S. housing market. Their troubles have threatened to worsen the bursting of the housing bubble, which has led to a surge in foreclosures.

A Treasury intervention could help Main Street borrowers by keeping interest rates on mortgages lower than they would be in the event of continued instability.Paulson's push to win authority was meant to reassure investors that the government wouldn't allow Fannie Mae and Freddie Mac to fail.In recent weeks, Treasury officials have been reaching out to foreign central banks and other overseas buyers of securities or debt sold by the two companies, to reassure them of the creditworthiness of these instruments. Homebuyers and holders of Fannie & Freddie debt are the likely beneficiaries of a U.S. Treasury plan to takeover the beleaguered mortgage giants, but it is less clear how shareholders will fare.

Fannie and Freddie have provided financing for 70% of mortgages originated in recent months, as purely private investors have fled the market. Worries about the firms' ability to weather the housing crisis has pushed up their capital costs in recent weeks, causing mortgage rates to rise. An intervention to stabilize the firms would help to keep mortgage rates down, helping potential homebuyers.

Investors in Fannie and Freddie, who had recently been bullish about the prospects of the two companies, clearly showed panic after the reports came out. Fannie shares, which closed Friday up almost 9.7 percent at US$7.04, plunged about 15 percent in after-hours trading. Freddie shares, which ended Friday up about 3 percent at US$5.10, dropped more than 18 percent in after-hours trading. The huge sell-off suggests that investors fear that pain will radiate to shareholders in both companies, which include many banks and foreign players. Fannie and Freddie have both common and preferred stock, the latter widely held by some of the nation’s largest banks because of a decades-long assumption that both companies were implicitly guaranteed by the federal government. Those affected will include foreign central banks and sovereign wealth funds also hold Fannie and Freddie preferred shares. Under virtually all of the plans under consideration, common shareholders would probably be wiped out.

Well, for once Asian markets will get to lead the way before the American equity markets get to react. Monday market should point towards a positive slant. The move will likely create a good platform for the US mortgage markets - i.e. lower rates, more participants, proper recapitalisation of affected units, a quicker rebound in property prices which will boost write backs eventually, allowing financials to come to grips with their losses and exposure once property stabilises - all pretty positive for equities. When I said Fannie & Freddie got their mojo back, it does not mean their share prices will fly, in fact it will do the opposite - the plan will mean admitting that the patient is in ICU (no more denials, despite the frequent coughing of blood by both). The patient is finally being treated, and the fear and instability created by "not treating" the patients are on the way to being allayed and eradicated. It will be bad for shareholders of Fannie & Freddie as the plan will be tailored NOT to benefit existing shareholders as doing so will be seen as a bailout.

p/s photos: Zhang Zi Lin