John Hempton on Frannie

Let me, for one, endorse pretty much everything he says:

Bronte Capital: The Reality Based Community and Frannie: I estimated the earnings power of Fannie Mae at about 10 billion per annum. Fannie has something near a trillion in debt... at 130bps over treasuries... Fannie had nearly no [net] earnings power... [with] losses in the book... around 80 billion.... The Government might have solved this problem by explicitly guaranteeing the debt and leaving the private ownership in place.... I would have thought the implicit guarantee was enough – but [the] 130bps [spreads] tell me it wasn’t.... Over the next couple of years then Frannie was effectively going to raise over a trillion dollars in US government debt.... [If] spreads [stay] 100bps or more... [the] cost to the Federal government of delay is... 10-20 billion annually....

The logical thing for the government to do in that circumstance is not delay. [The alternative is to cross your fingers and hope that the debt spreads on Frannie debt dropped to 30bps on their own accord.] My understanding of US politics (erroneous it seems) suggested to me that this administration would not want to explicitly socialise the problem. Moreover many decisions of this administration are best described by delay and crossed fingers. So I am staggered by rapid logical action. But so be it and for once I think a Bush administration action is sensible.

But I am more staggered that the market forced the action. I thought that the market would see the implicit guarantee for what it was and trade Frannie senior debt at low spreads. But reality has the ability to get in the way of many things.... This must really pain the Republicans... reality got in the way of ideology.

There is a second hard decision – which is what to do with the preferred. Any solution that leaves the preferreds as senior to the Government capital would indicate that the Republicans have dumped ideology entirely. I am not sure that they should wipe out the preferreds – but I would have a jaundiced view of any deal which substantially pays the preferreds before the government makes a reasonable profit on the capital that they are putting it risk.

As I said, when I do the numbers the outstanding preferreds look good. There's $10B or so of annual earning power in Fannie if it can borrow at Treasury rates--as long as the economy as a whole doesn't go deep down the toilet.

Comments

[shah8]

Many republicans, including GW Bush are very much anti-Fannie Mae and Freedie Mac. The organization is relatively independent of the current republican corruption apparatus, not to say that they aren't very corrupt themselves.

I am not certain about whether or not FM's needed nationalization or not, but I can feel reasonably comfortable in saying that the Bush Admin do not have good motives.

[jim]

The outstanding preferred have to be a very long shot indeed. The Government-held senior preferred gets paid first (at 10%!, 12% if deferred). Any further capital injection the Govt. has to make will be in the form of senior preferred. It was explicitly stated that the dividend on the preferred is "eliminated" (not merely "suspended"). I don't see any likelihood of there being any sort of return on the existing preferred.

[jim]

Oh, and don't forget that starting in 2010 the Govt. will start charging the GSEs fees for having saved them. Any profit that doesn't go to paying the senior preferred will be soaked up in those fees.

[albrt]

But it seems pretty clear that the eventual goal is to create fully privatized baby GSEs. Somewhere around the time that the GSEs threaten to become profitable they will be divided up and spun off, so the question is whether the existing equity will still be alive at that point.

Since most of the GSE preferred stock will be bought up at bargain basement prices by extremely wealthy and well-connected vulture speculators over the next couple of years, it seems likely to me that the existing equity will be kept alive until the spin off. There won't be a real bankruptcy, so there are no rules saying the equity has to be cancelled. And the previous investors will have been visibly punished, so I don't see any likely scenario where there would be a big political benefit to changing the deal and cancelling the existing equity.

Besides, we have a guy from the Carlyle group and a McCain campaign official being appointed as the new CEOs, so how is it possible to lack confidence?

[Ken Houghton]

"The logical thing for the government to do in that circumstance is not delay."

Correct. Have they changed the plan from yesterday, when they decided to put in a bit at a time on a quarterly basis?

And forget the preferred holders--they haven't explicitly said the common equity holders are holding the 21st century equivalent of the Tsarist Government bonds.

So unless they have also announced that the stock is eliminated--assuming jim above is correct that "eliminated" is the word used to describe the obligation to preferred holders, I do mean the stock is eliminated, not just the dividend--it's another Bush Administration plan that will fit perfectly into Daniel Davies's Three Laws: The U.S. taxpayer will pay Son-of-Roger-who-acts-like-Harry Mudd for running the firm into the ground, the U.S. government will hemorrhage cash for an extended period because the Administration wrote another check for the next Administration to pay, and the taxpayers will end up paying more money because of the first two.

And some idiot a few years from now will write about the glories of how "free-market capitalism" will work in the U.S. mortgage industry--just as it worked so well after the S&L crisis.

[baileyman]

FNM and FRE have been Democratic honey pots for a long time. What party are the new managers? This should indicate which way this is going. My bet is they will morph into Republican honeypots at some point.

As of June, FNM makes about $1.1b quarterly pretax on guarantee ops, their legitimate business. That's maybe $800m after tax, $3.2b annually, worth maybe $50-60b.

The remainder of the business is a US credit quality arbitrage business, a $750b hedge fund, used by management for about 25 years to funnel benefits to themselves, and a totally illegitimate operation for FNM. This is where the balance sheet size is.

The risk in the securities investment portfolio (hedge fund) is partly fraudulent lending, inappropriate lending, but mostly lending against inflated assets. These are down on average about 15%, but there may be another 15% to go. The distribution of the rate of housing decline makes it hard to see how big the losses could be.

Only 26% of the portfolio has LTVs greater than 80%. Perhaps the remainder are on average 90%. This would mean that 3/4 of the portfolio could already be to underwater borrowers. The remaining 1/4 could follow, if you expect any additional decline. The distribution of losses matter a lot here, since if the additional decline is for already underwater borrowers, well, they can only default once. Not all borrowers are average. And underwater borrowers default.

On selling repossessed property, a 20% cost to market could be at the low end.

So, the haircut on the 75% low LTV part of the portfolio could be 35% or a bit more, and for the 25% high LTV part, maybe 25%. Total maybe 30-35%. That's the magnitude people should be thinking about. Shockingly large?

Total equity was $41b or about 5-6% of the $750b. Totally inadequate to the task.

Treasury takes a senior preferred and says they'll put in whatever it takes to stay positive. That is, they've bought the company.

Junior holders should expect nothing.

[jim]

It's the dividend which is eliminated, not the preferred stock, but if there's no dividend, all the preferred stock represents is a preferred claim on assets in the event of a liquidation which the Govt. has just guaranteed will never happen. Even if baby GSEs are spun off in the future, we don't know that holders of existing preferred will get any equity in them. Personally, I wouldn't bet any actual cash that there will be baby GSEs. It may be that Paulson would like to see them, but he'll be long gone by the time this stuff settles down.

[albrt]

I would put the odds of participation in an eventual spinoff at less than 50% for existing preferred holders, but the returns could be 20x or more if it happens. I would not make a significant investment, but if GSE preferreds hit the pink sheets below a dollar I will buy a few.

[christofay]

We have been appointed by Paulson to pick up Frannie's load.

Paulson will be long gone into the private sector looking to Hoover or as Pres Failure says replenish the coffers.

It's going to be hard to say no to the next special interest group, the Big 3 of Detroit, looking to tap the Federal govt. We also have the Alaskan example of using the Federal govt as a sponge as long as the sponge holds water. Drying out the sponge would reduce risk which is why cutting defense (offense) spending is important. We're spending money everywhere so we should take a first and big whack at a big consumption expense.

Roubini is outraged.

Any plan that involves innovative finance sphere, Paulson, the Cheney administration, Greenspan or Greenspan Jr, did I leave anyone out?, is never smart.

[christofay]

gotta do someting, gotta do someting, gotta get the govt to do someting now

If we stuck to our rules and delisted Fannie when it couldn't follow the rules earlier in the decade we could have started winding down this beast earlier. It was fraudulent accounting during the Clinton administration and fraudulent accounting during the Cheney administration and fraudulent accounting up till next year. In the meantime Palson is getting the Treasury into the mortgage markets where the A list innovative finance firms still have toxic junk to unload.

If we are confused by the status of the common and the preferred, what about the weapons of wealth destruction, the derivatives?

We are clever but we are not smart.

[christofay]

I love the smell of government emergency over the weekend.

[christofay]

Carlyle has lost more money on Freddie and Fannie bonds than they ever made on F & F bonds. Palson has already said that the Carlyle official seconded to Fannie will have his oversized compensation protected

As to the "mission" of Freddie and Fannie a cynic would say of course it has a notable community enriching mission; that's required so the contraption can get in gear enriching top management overseeing the fraudulent accounting and enriching innovative financial sphere. Mozillo (the guy in the center in the photograph in the I'm Ready for My Closeup, Mr. DeMille... post) of Countrywide supported the F & Fs' mission. We can't have the federal govt directly sending the billions directly to our elites; there has to be a little community enriching packaging to pretty it up.