The Endgame Nears For Fannie and Freddie

By JONATHAN R. LAING
The almost inevitable government recapitalization of Fannie Mae and Freddie Mac will likely wipe out investors—and management.

IT MAY BE CURTAINS SOON FOR THE MANAGEMENTS and shareholders of beleaguered housing giants Fannie Mae and Freddie Mac . It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?"


Martin Kozlowski
Many of Fannie's and Freddie's credit losses come from risky mortgages that the agencies bought or guaranteed in recent years to boost their market share.
Heaven knows, the two government-sponsored enterprises, or GSEs, both need resuscitation. Soaring mortgage delinquencies and foreclosures have led the companies to gush red ink for the past four quarters, and their managements concede the outlook is even grimmer well into next year. Shares of Fannie Mae (ticker: FNM) and Freddie Mac (FRE) have lost around 90% of their value in the past year, with Fannie now trading at $7.91, and Freddie at $5.88.

Similarly, the balance sheets of both companies have been destroyed. On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.

What's more, the fair-value figures reported by the companies may overstate the value of their assets significantly. By some calculations each company is around $50 billion in the hole. But more on that later.

Bringing Fannie and Freddie to heel will be difficult for the Bush administration, despite the GSEs' (Government-Sponsored Enterprises') parlous financial condition. Consider their history. In the early 1980s Fannie was effectively insolvent, but the government allowed it to continue operating. Eventually long-term interest rates dropped, bolstering the value of the company's mortgages and bringing it back from the brink. Earlier in the current decade Fannie and Freddie successfully fought a full-scale attempt by the White House and some brave Republican legislators to clamp down on their operations, after they were caught perpetrating accounting frauds.

Note, too, that Fannie and Freddie have nonpareil lobbying operations and formidable political strength, owing to their hefty donations and penchant for hiring former political operatives. Besides, the agencies claim they've landed in their current predicament through no fault of their own. As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

MAKING SENSE OF THE STORY FOR THE CONSUMER

· According to the Barron's article, which states "should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises," consumers would be led to believe that a government bail out is the only option. Although a cash infusion may be needed, it is not likely that the Treasury would purchase an equity stake in either Fannie or Freddie. Additionally, the Treasury Dept. must negotiate an agreement with the GSEs. Fannie and Freddie continue to raise capital on their own and some reports show that the GSEs are looking for private-equity firms or outside investors to provide the financing, which would help raise capital and reassure Wall Street.

· The article also states, "In the early 1980s Fannie was effectively insolvent, but the government allowed it to continue operating." Many consumers are not aware of how the GSEs serve the market or what their roles are. Unlike banks, which lend directly to consumers, Fannie Mae and Freddie Mac operate in what is known as the "secondary mortgage market." They purchase or guarantee loans from direct lenders in the "primary mortgage market" and either hold onto them until they mature, or sell the loans in the form of mortgage-backed securities. By the GSEs guaranteeing or purchasing the loans from banks, Fannie and Freddie are able to fulfill their congressional mission and supply an affordable and stable source of capital to lenders, allowing them to offer more home loans.

· Due to tighter lending standards, it is becoming increasingly more difficult for borrowers to secure home loans. If Fannie Mae and Freddie Mac did not guarantee or purchase primary lenders' loans, the cost of homeownership would dramatically increase as lenders would experience an even greater capital shortage.

· Many financial institutions in the mortgage business are experiencing losses, and while the GSEs are no exception, their portfolios continue to outperform the majority of lenders in the market. Additionally, unlike private investors which seem to have abandoned the mortgage market, Fannie Mae and Freddie Mac are fulfilling their congressional mission to provide an affordable and stable flow of capital to home-loan lenders.