This weekend's news that the Federal government has placed Fannie Mae (FNM) and Freddie Mac (FRE) into conservatorship likely marks a bottom in financials and provides further support for the July lows. Below I have tried to summarize some of the key points that I believe warrant further attention for those investors trying to be informed about the situation.
First, the common stock holders will see their share in the equity of Fannie Mae fall to 20% of the pre-conservatorship level amounting to $ 8.2B as of the end of the second quarter (total equity at the end of the second quarter was over $41B). Given the distressed nature in the stock, the shares, even after the dilution, are still worth $7.66 if they company were to trade at a book value that would reflect the dilution caused by government’s warrants. Such a price would not reflect the effect of additional losses going forward and as such cannot be used to properly value the company; nevertheless, it is an interesting figure.
Secondly, the Treasury will be purchasing $20B of MBS securities a month through 2009. Such an action will allow Fannie Mae to get a much better price for its securities then it would have been able to get in the public markets. This will additionally guarantee the company a large boost to its fee income as it will likely be guaranteeing the securities as well originating them.
Additionally, the Treasury’s new credit facility will allow the company additional borrowing sources at what will undoubtedly be fairly generous rates. This should allow the company to continue to function normally and allow for a safe rundown while at the same time allowing the company's net interest margins to expand from current levels, boosting net interest income.
The fourth item I found interesting was the lack of comment on the company’s mortgage guarantee business. To me this can be interpreted that it is doing surprisingly strong and will likely be a significant contributor to the company’s turnaround going forward, should their rates begin to rise dramatically. The problems at the company appear for the most part to be centered but not isolated in the company’s mortgage portfolio.
Another item that caught my attention was the distinct possibility that the shrinkage of the company’s mortgage portfolio could have potentially gargantuan effects on the financial markets. Earlier this year the two GSEs were involved in over 80% of all mortgages originated in the U.S. so I would be leery of seeing these two company’s shrink their portfolios until there is a system in place that ensures that publicly traded banks will be able to ensure that there is a perpetual mortgage market in operation. Otherwise we risk the possibility of a global market failure should no government entities such as Fannie Mae and Freddie Mac be in existence to prop up credit markets during the next crisis. Fortunately, it appears we will have time to work on that, as the portfolio will only be forced to shrink 10% a year starting in 2010.
Finally, there were these startling tidbits in Secretary Paulson’s remarks on Sunday:
“The federal banking agencies are assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.”
“The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized." The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.”
While Paulson & Co. assure us that the number of banks effected will be small, I can not be sure, as a fair number of large regional banks own preferred stock in the companies, which will be at least temporarily impaired. In addition, smaller banks invested in these GSEs and there is as a result the distinct possibility that they could have had significant positions in the company’s common stock, in addition to positions in the GSE’s preferred stocks, as it was viewed as relatively safe until last August. Whether or not this will cause any banks to go under is hard to say; however, it can be concluded that it is not a good thing and will likely further strain the banking system and by default the FDIC’s investment fund.
During the remainder of 2008 and through all of 2009, it will be interesting to see how Fannie Mae holds up. The placement of Fannie Mae into conservatorship signals the failure of the company’s former management team’s effort to manage earnings in such a manner as to try to spread the financial impact on the company over a longer period. While I would expect the company to take significant charges in the immediate future as it adds to reserves, I do not expect the company to become utterly insolvent and to run through its capital overnight. In fact, lower borrowing costs, the elimination of dividends, the sale of MBS securities at par to the Treasury and a surge in fee income, as I talked about here, should allow the company to do surprising well. At some point I would not be surprised to see the company emerge from conservatorship and for common stockholders to be left with shares that are much more valuable then what the market will likely value them on Monday morning. That being said I do not endorse buying shares of Fannie Mae at this time. It is however important to realize that these two companies have not filed bankruptcy.
The Bush administration’s action shows their willingness to do whatever necessary to guard against cataclysmic financial failure. In placing these two GSEs into conservatorship, the administration has thrown its ideological beliefs out the window. While this was surely necessary, it marks a reaffirmation of the high level of involvement by the Federal government in financial markets for years to come. This action effectively opens the door for massive governmental involvement in the insurance, reinsurance and banking industries. The opportunity for corruption and government mismanagement is extraordinary, fortunately the Treasury appears to be willing to use a decidedly market based approach to dismembering these beasts leaving some hope that significant errors will not be made.
If we can manage to avoid a massive derivative/CDO blowup, we may just have witnessed a definitive bottom in financial stocks and in the financial markets as a whole.
