Fannie, Freddie Bailout Is Not a Cure-All

Financial stocks rallied on the federal government's bailout of Fannie Mae and Freddie Mac, but problems remain.
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Editor's note: Our "On the Brink" series will provide daily insight into the financial firms facing capital shortfalls and the growing pressure from short sellers in the market.

The federal bailout of

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

set off a rally in financial stocks, but the only meaningful solution to the sector's downturn is something that even a limitless supply of capital simply can't provide: Time.

The initial phase of the mortgage giants'

rescue plan

, outlined by Treasury Secretary Henry Paulson on Sunday, is intended to bring mortgage rates down and improve pricing for mortgage-backed securities. In theory, it will spur the housing market by making homes more affordable and lift one cloud of uncertainty that has hung over housing debt.

But other factors will continue to drag on the housing market: High unemployment, low wage growth, paltry consumer confidence, and the declining home values that are causing many Americans to abandon their homes and mortgage payments in the first place.

"

The decision to buy a house is driven by the potential homeowner's confidence about their job and income, not mortgage rates," RBC Capital Markets analyst Gerard Cassidy wrote in a note Monday. "Mortgage rates drive the size of the home purchased."

Cassidy said the situation will improve only with time as banks filter through issues not only with housing, but other bad debts like non-residential construction loans. He estimates that will take two to three years' worth of further losses on the part of homeowners, lenders and investors.

The biggest losers so far, of course, have been shareholders of Fannie and Freddie, who each saw their equity value plunge more than 82% to below $1 a share on Monday. Some analysts predict further drops, with price targets as low as 25 cents, "sell" ratings galore and downgrades from major credit-ratings firms.

Some of those feeling the pain are financial firms themselves, which are already suffering from housing-related losses. Companies large and small hold common or preferred shares of the mortgage companies, which once provided a healthy stream of dividends and value gains. Now, major players like

JPMorgan Chase

(JPM) - Get Report

and

Wells Fargo

(WFC) - Get Report

as well as smaller banks and thrifts like

Sovereign

(SOV)

and

Westamerica

(ABC) - Get Report

will be cumulatively writing off billions of dollars worth of stock.

JPMorgan alone said it once had a $1.2 billion portfolio of Fannie and Freddie's preferred shares, the value of which has mostly evaporated by now. Wells Fargo reported on Monday that it will face impairment charges on $480 million worth of government-sponsored enterprise stock, and on Friday, Westamerica said it once held $44.5 million worth of such assets.

Citigroup

(C) - Get Report

,

Bank of America

(BAC) - Get Report

and

KeyCorp

(KEY) - Get Report

have also stated exposure to GSE shares, but not quantified the amount.

Other banks mentioned by analysts as having significant exposure are

Gateway Financial

(GBTS)

,

Midwest Banc Holdings

(MBHI)

,

M&T

(MTB) - Get Report

and

Astoria Financial

(AF)

.

But whereas national banking behemoths almost certainly have enough capital to absorb GSE-related losses, smaller banks might not. According to a Fox-Pitt Kelton report, GSE preferred stock represents about a 10.8% portion of Westamerica's common equity, 7.7% of Sovereign's, 6.8% of Astoria Financial's and 2.5% of M&T's. By contrast, that compares with just a fraction of a percent of JPMorgan's,

Fifth Third's

(FITB) - Get Report

and

National City's

(NCC)

. An earlier report from KBW said Fannie and Freddie stock accounted for more than 30% of tangible capital at both Gateway and Midwest.

Fox-Pitt analyst Carolina Walker called the government intervention a "net positive" for the financial sector, but noted it is still "likely to experience higher net charge-offs and additional loan-loss reserve builds in upcoming quarters."

Certainly not all shareholders were suffering after the bailout was unveiled, with the

Dow Jones Industrial Average

rallying more than 3% and financial stocks up more than 5% early in the day, despite Fannie and Freddie's plunge. Similarly, the spread between the GSEs' debt and Treasury bills narrowed, since the government restored bond investors' faith. They will be second priority for repayment, behind taxpayers and far ahead of equity investors.

Don Wordell, manager of the

RidgeWorth Mid Cap Value Fund

, says the biggest position in his portfolio is now National City, and predicts more gains ahead.

In a change of tune from recent market sentiment, Wordell says "the winners are going to be the banks that have big mortgage exposure on their books. ... The losers will be the banks that have a big part of their capital wrapped up in Fannie and Freddie shares."

Gerry Sparrow, who manages the

Sparrow Growth Fund

, was seeking out opportunities in shares of financial firms that stand to benefit by taking over the GSEs' business. He named Citigroup and Wells Fargo as banks he considers undervalued, and thinks that recent incremental improvement in the housing market, consumer confidence and oil prices will be sustained. He also noted that the price-to-earnings ratio on the Dow is at 14, the same level as the last market bottom in 2002.

"The market is poised to rise," says Sparrow.

Even Richard Bove, an analyst with Ladenburg Thalman -- who calls the Fannie-Freddie bailout a "very sad day for the American financial system and the capitalist economy" in a client note -- also characterizes it as a time for profit-making.

"I would buy a bank stock today," he writes.

Larger, stronger, more diversified banks will come out ahead. But the one question that remains -- and likely won't be answered for months or years -- is whether taxpayers will be winners or losers in this equation.

A Congressional Budget Office report in mid-July gave a 50-50 estimate that the bailout would cost taxpayers $25 billion, with a 5% chance that it could reach up to $100 billion.

Paulson asserted on Sunday that "there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains." But he also noted that "in the end, the ultimate cost to the taxpayer will depend on the business results of the GSEs going forward."

Bob Andres, chief market strategist for Portfolio Management Consultants, says the positive market sentiment won't last long. He attributes initial gains mostly to day traders and hedge funds, rather than long-term fundamental investors.

"The euphoria that you see today will dissipate quickly," Andres asserts. "The problems are there and we can't wish them away. Time is going to play its role."