Fannie & Freddie Update
Posted on: August 19, 2008 - Email Article - Printable Version
While on vacation this previous week, I had the opportunity to take a hike with a curr
ent employee of Freddie Mac. As much as I could tell she wasn’t looking to have a conversation about work in the middle of Vermont’s green mountains, I could not help but push the subject. As we chatted, she filled me in on some of the details of the past few months. While she didn’t cover much I did not already know, one thing did surprise me. Finishing our conversation, the woman looked at me and said, “I’m not sure I’m going to have a job in six months.” She then continued up the mountain unperturbed, as if the information was nothing new to her. I was left to ponder this incident for the remainder of my vacation only to return home on Monday and see Fannie and Freddie back in the headlines.
Agency Profitability
Both Fannie Mae [FNM: 0.68, -0.002 (-0.29%)] and Freddie Mac [FRE: 0.75, -0.07 (-8.54%)] are Government Sponsored Enterprises (GSEs) privately owned but federally chartered to deal in the U.S. mortgage market. Reliable agency profitability is essential to produce the credit fundamentals necessary to avoid direct government backing. The government regulates the GSEs with policies intended to measure and control risk. The conservative management of these agencies, along with the implicit backing of the government, has traditionally permitted Fannie and Freddie to represent the highest credit quality aside from U.S. Treasuries.
The exceptional credit quality of the agencies allows them to issue debt and borrow money at much lower rates than other AAA financial firms. Meanwhile, in lending funds to buy mortgages from the local banks, they earn a relatively higher rate of interest. The profitability of the GSEs comes from this arbitrage between the rate of interest paid on funding and that received on their lending activities (mortgage purchases). The beauty of this business model is that the larger the arbitrage spread derived from their credit quality, the bigger their profit. This enhanced profitability bolsters their credit quality, allowing them to borrow at even better rates. As you can see, an almost self-fulfilling prophecy business model has allowed Fannie and Freddie to thrive since their creation.
A Business Model in Trouble
In previous times of market duress, we have almost always seen Fannie and Freddie benefit in a ‘flight to quality’ bid. The basic problem this time around is that at the heart of this economic downtur
n is the mortgage market—of which Fannie and Freddie owns or guarantees almost half. As other financial institutions tightened lending standards at the onset of the credit crunch beginning last July, the government leaned on Fannie and Freddie to provide liquidity to the struggling housing market. While using them as a crutch to prop up the faltering economy, Paulson & Co. seemed to loss sight of the fact that the GSEs are private institutions with shareholders to answer to.
What Happened?
July 9, 2008 shares of Freddie dropped 24% to close at $10.26 (-83% YoY) and Fannie shares fell 13% to $15.31 (-76% YoY) as equity investors fretted the implication of government intervention. The debt remained relatively intact as the theory ‘too big to fail’ continued to hold following the Treasury’s backing of Bear Sterns. However, with delinquency rates around double what they were a year prior for both companies, an already jittery market quickly moved their money elsewhere. Interestingly, the Treasury market sold off on this news. In a true display of how panic-stricken the market was, there were rumors that the U.S. national debt was going to be downgraded (fearing that the Treasury was going to have to nationalize and assume the debt of Fannie and Freddie) and U.S. Treasury Credit Default Swaps (CDS) blew out to its widest levels. Who knew Treasury CDSs even existed?
In order to shore up confidence in the two companies, Paulson announced the Treasury would lend money to the companies or make an equity investment if necessary. Additionally, the Federal Housing Finance Agency (FHFA) was created as a replacement regulatory body for Fannie and Freddie.
Back in the Headlines
While all was calm on the GSE front for a couple of weeks, they found themselves center stage again Monday following a glut of downtrodden news. Fannie and Freddie stocks were each down over 22% after a Barron’s article asserted the companies would soon need to be recapitalized by the Treasury; a move that would essentially wipe out the existing shareholder value. With American Express [AXP: 20.05, -2.35 (-10.49%)] issuing its debt Monday at junk bond spreads of T+425, it is hard to imagine a financial institution making the necessary capital infusion ( probably +$10 billion) in either company that have market caps of just $8.5B and $4B. That being said, if the mortgage market continues to deteriorate, the only viable option for Fannie and Freddie may be the U.S. Treasury.
In my opinion, investors are pretty much handcuffed until a clearer picture emerges. Because this is an issue with no real precedence (excluding possibly the government’s backing of the FDIC during the Savings & Loan crisis), investors speculating at the government’s next move are doing just that—guessing.
-Adam Brown
Disclaimer: None
The Following Stocks Were Mentioned In This Article: AXP, FNM, FRE
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Great article Adam. I don’t know if I would be too worried if I were the Freddie Mac employee that you hiked with. The federal reserve seems more than willing to throw money at this problem until it goes away.
In my opinion, I feel like this was an opportunity missed to let the two firms fail. Clearly, there are some major holes in their business model. I know there are two schools of thought in this, but I’d much rather let the natural capitalist structure take it’s course then offer bailouts to firms in need like F-Mae and F-Mac.
I would worry about my job, although Fannie and Freddie are GSEs, they are answerable to their shareholders. The government will back them but they need to exhaust other avenues of gaining capital first. Cost cuts can provide a lot of necessary capital and are doable in this operating environment. I wouldn’t be surprised to see some people let go due to this.
Santosh Sankars last blog post..Fannie & Freddie Update
Yes, they should be cutting costs. I was just using the post as an excuse to defend my beliefs on government sponsored bailouts. You caught me, haha.
I agree with you on that, the markets should be allowed to take their course and in the process there will be businesses that fail- all apart of an efficient economy.
Santosh Sankars last blog post..Target Earnings Recap
Letting Fannie and Freddie fail would certainly be an interesting experiment in capitalism. However, when you think about it, the GSEs by their nature are not really capitalist vehicles. That aside, following the Treasury’s backing of Bear Sterns, they have no real choice in the matter at this point.
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