The Tycoon Report

Take A Load Off Fannie

"And put the load right on me," sings Treasury Secretary Henry Paulson, Fed Chairman Ben Bernanke, and the rest of the band as the government mills over the situation at mortgage financing giants Fannie Mae (FNM) and Freddie Mac (FRE).

Shares of Fannie Mae and Freddie Mac fell more than 40% in the premarket on July 11 as investors were startled by comments from an unnamed source about the potential for government intervention. Apparently, a person familiar with the matter, who was assumed to have been involved with the situation, commented that as a reaction to recent capital concerns, the government was considering a takeover of both companies. In such an event, shares of FNM and FRE would essentially become worthless.

The news came after a July 10 meeting on Capital Hill, with Mr. Bernanke and Mr. Paulson in which the economic overseers claimed that our financial infrastructure was outdated and needed to be changed, while also noting that they would almost certainly take action should another financial institution be at risk for another Bear Stearns type situation. The meeting added fuel to the Fannie/Freddie fire, which began three days earlier when analysts noted that FNM would need to raise more than $40 billion of capital after an accounting rule (FAS 140) concerning off-balance sheet assets was revised. Legislators were quick to point out that Fannie and Freddie’s failure were unacceptable given the potential implications on the housing market.

The bailout news seemed a little extreme to us considering Mr. Bernanke himself had already reassured the market that the Office of Federal Housing Enterprise Oversight (OFHEO) was watching the Company’s situation carefully and that it saw no liquidity concerns. Yes, it is true that Fannie and Freddie are at risk of losing several billion dollars, perhaps tens of billions over the next couple of quarters, but the funny thing about their capital positions is that they have a number of moving parts that other Companies don’t have. Firstly, there is the matter of the previously mentioned FAS 140 accounting rule. We believe that Fannie and Freddie will be exempt from such a rule given the damage it would do to the companies by forcing off-balance sheet items (of which Fannie holds more than $3 trillion) to be recognized on its balance sheet; government regulators would simply not allow such an event to take place.

Secondly, there is the OFHEO, which has the power to change Fannie and Freddie’s restrictions, which includes its capital requirement for its outstanding assets. Should it be deemed relevant, the agency could lower the Companies’ capital requirements, thus reducing the amount of capital needed to cover its assets. Finally, there is also the possibility that the government would simply give Fannie and Freddie money to account for any potential losses; of course, combinations of each of these scenarios could be utilized as well.

It appears as though Bernanke and the gang have already authorized option number three by allowing the Companies to borrow from the Federal Reserve directly (via the discount window) should it be necessary, as announced on July 13. And in a more creative play on the same theme, Hank Paulson is requesting that the Treasury be given the right to purchase equity shares of FNM and FRE, allowing the government to fund the companies through partial ownership when/if necessary, without fully erasing stockholders’ equity. The Treasury may also extend its credit lines to the companies. If the Treasury were to make an equity investment in FNM and FRE, shareholder’s value would be further diluted, the last thing FNM and shareholders want considering the precipitous drop over the past year. There has been no indication that the government intends to purchase equity immediately. In fact, neither Fannie nor Freddie have moved to take advantage of the Federal Reserve discount window that opened on Sunday, citing ample liquidity for the time being. There is also the issue that if the Treasury were to purchase large portions of Fannie and Freddie, the value of the dollar would likely decline further given that the Federal Reserve’s balance sheet would be negatively affected; so in that sense, Mr. Paulson must be careful not to go overboard. In fact, the government already has a mandate in place relating to the acquisition of the government-sponsored enterprises (GSE). The law states that a takeover should occur if the companies’ capital reserves are to fall below half of their capital requirements set by the OFHEO. As it stands, both Fannie and Freddie are still well above their capital requirements, and between the two Companies there is approximately $70 billion of wiggle room before falling below that threshold. The most pessimistic estimates call for losses of $5 billion to $6 billion pretax a piece in the current quarter.

The moral of the story is that Fannie and Freddie will survive, though there will more than likely be bumps along the road for shareholders. Fannie, Freddie and the government still have a lot of tricks up their sleeves. Subsequently, the mortgage industry will not see the floor drop out beneath it, but it will take a concerted effort from the Fed, lenders, realtors, and even us ordinary citizens, to get things back on track and, without a doubt, there is still a long way to go.

Written by David Urani a Research Analyst for Wall Street Strategies (www.wstreet.com) specializing in the homebuilding, staffing, medical devices, and logistical services industries.