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Sunday, September 07, 2008

Fannie & Freddie Thoughts

by Calculated Risk on 9/07/2008 06:28:00 PM

When the Paulson Plan was announced in mid-July, my initial reaction was:

It seems the plan is bad for equity holders, but good for debt holders ... and potentially bad for taxpayers ...
Nothing has changed.

Although the common shares will continue to trade, they are further behind with new senior preferred shares being issued to the Treasury. And even if the common is worth something again someday (more than the option value they will trade at soon), the Treasury received warrants that will significantly dilute the common.
Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price
On the other hand, the debt holders should see a rally tomorrow since the Treasury has guaranteed they will provide enough capital such "that each enterprise maintains a positive net worth".

Those are the easy calls.

The bigger questions are (in no particular order): 1) How much does this cost taxpayers (if anything)? 2) What happens to treasuries? 3) What happens to the existing preferred? 4) What happens to FDIC insured banks that hold the existing preferred? 5) What happens to the stock market? 6) What happens to mortgage rates? 7) What happens to the housing market and the economy?

These are some of the questions we will be discussing.

Just like with the common, the existing preferred will continue to trade (although the dividend is eliminated).
"The common stock and preferred stock dividends will be eliminated, but the common and all preferred stocks will continue to remain outstanding."
This will have a significant impact on some banks, as the FDIC noted earlier today. Many banks will have to take write-downs (as they mark to market), and some smaller banks will probably fail.

UPDATE: From Fitch: Fitch Affirms Fannie Mae & Freddie Mac's 'AAA' IDR; Lowers Pfd Stock; Sub Debt on Watch Evolving
Fitch has also downgraded FNM and FRE's preferred stock to 'C/RR6' from 'BBB-'. The downgrade of the preferred stock reflects the subordination of the preferred to any Treasury interest and interest payments are unlikely to resume in the foreseeable future. Thus, any recovery is expected to be minimal.
emphasis added
As far as treasuries, I expect a sell-off. This is uncertain, but it would seem investors have a choice between Fannie and Freddie debt and Treasuries (although treasuries are state tax free). The Ten Year closed on Friday with a yield of 3.66%; I expect a sell-off.

I suppose mortgage rates will decline as Fannie and Freddie's borrowing costs decline. Also the Treasury will be buying GSE MBS and that should push down mortgage rates:
Treasury will begin later this month by investing in new GSE MBS, which are credit-guaranteed by the GSEs. Additional purchases will be made as deemed appropriate. Treasury can hold this portfolio of MBS to maturity and, based on mortgage market conditions, Treasury may make adjustments to the portfolio.
I suppose the stock market will rally tomorrow. See Bloomberg Stock Futures. But this is just short term. Longer term, investors will look at the impact of the economic slowdown on earnings - and that picture is still grim.

The cost to taxpayers is also very unclear. It is possible that taxpayers will not be negatively impacted in the long run. This depends heavily on the losses in the retained portfolios of Fannie and Freddie, and the cash flow from the good portion of the portfolio, and also on future defaults and house prices. Even if the Treasury has to purchase $50 billion or $100 billion in senior preferred shares to maintain the positive net worth of Fannie and Freddie, the Treasury will own the first equity in line to be paid off from future profits (assuming future profits). This makes the losses very unclear.

For housing, this doesn't change anything. Housing fundamentals remain the same: excess supply (especially distressed supply), tighter lending standards, and prices are still too high compared to incomes and rents. The possible slightly lower mortgage rates are almost inconsequential compared to supply and price issues.

And the economy is still in recession that will linger for some time.

And finally how, when, and into what do Fannie and Freddie eventually transition? This will be a huge issue for some time.

Just some thoughts ... I'm very open to alternative questions and outcomes.