Fannie Mae (FNM) and Freddie Mac (FRE) are dominant players the bond market. Not only are they the biggest non-Treasury issuers of straight-debt securities, mortgage-backed bonds guaranteed by the two giants represent over 30% of the total taxable bond market. Therefore, the problems at the GSEs probably touch just about every investor directly in a way few other companies would.
While delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae), the fact is that both companies employ tremendous leverage, and therefore, losses even mildly above historic norms are likely to put huge pressure on the company's equity.
In addition, Freddie Mac has
yet to complete the $5.5 billion capital raise they promised in May, and given market conditions, this will be all but impossible without government intervention. So I'm not here to challenge the plunging share price of either Fannie Mae or Freddie Mac.
But there are three really silly things being reported in the media right now that need clearing up.
First of all, Financial Accounting Standard (FAS) 140 -- which requires off-balance-sheet assets and liabilities to be placed back onto the balance sheet -- has nothing to do with anything. Or at least, it should have nothing to do with anything. A revision to FAS 140 would tighten the rules about off-balance sheet accounting.
Based on how both GSEs currently operate, this would probably require both Fannie Mae and Freddie Mac to bring their guarantee portfolios on balance sheet. Under current statues, the GSEs' minimum capital required is 0.45% of their guarantee portfolio and 2.5% of their aggregate on-balance-sheet assets.
So taken literally, the GSE's capital requirements would increase dramatically if their entire $4.5 trillion guarantee portfolio were brought on balance sheet. The commonly reported number is $43 billion for Fannie Mae and $38 billion for Freddie Mac.
Of course, it's ridiculous to think that regulators would allow an accounting-rule change to dictate the GSEs' minimum capital. Economically, the GSEs are no more or less safe whether this stuff is on balance sheet or off. It's especially ridiculous given that a capital infusion of that level would be impossible to achieve in almost any market, much less now.
Plus, the GSEs' alternative would be to sell massive amounts of mortgage-backed securities (MBS) on their books, which would benefit exactly no one. Indeed Office of Federal Housing Enterprise Oversight (OFEHEO) director James Lockhart has said point blank that FAS 140 should not apply to the GSEs and that accounting changes would not drive a capital change.
What is even more ridiculous is to suggest that Fannie Mae and Freddie Mac do not have access to cash. Note I didn't say capital, I said cash. The debt and securitization markets are wide open to both companies, with senior debt spreads no more than 20bps higher this week than the average for June. This doesn't help them to raise capital, but it does mean that neither is in danger of running out of cash.
That leads us to the final silly thing being bandied about: that a bailout of either or both would be too expensive for the government to handle. In reality, a government bailout would probably involve taking the companies into receivership and directly backing their debt. It might result in Fannie and Freddie being folded into FHA.
Either way, it would result in taxpayers being on the hook for mortgage losses, but wouldn't involve the government writing some gigantic check up front. Taxpayers would first use the GSEs' rather large asset base first, so whether it would wind up actually costing tax payers anything is unknown. Comparing the size of the GSEs' guarantee portfolio ($4.5 trillion) to the national debt, or some such, is a spurious comparison, to put it politely.
This is by no means a recommendation to buy either the common or the preferred stock of either company. The former would almost certainly be wiped out by a Treasury-led bailout, and the latter may as well. And the Treasury will probably not wait for the companies to actually run out of cash before acting. The resulting contagion would be too great. But it's not likely that anything will happen to either senior debt holders or MBS holders. Today's action on the senior debt spreads bears this out, as they have moved about 20bps as of the open this morning.
At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.
Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback;
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