Failure Is Not an Option For Fannie and Freddie - Barrons.com

Failure Is Not an Option For Fannie and Freddie - Barrons.com: "FRIDAY, JULY 11, 2008
UP AND DOWN WALL STREET DAILY
Failure Is Not an Option
For Fannie and Freddie
By RANDALL W. FORSYTH | MORE ARTICLES BY AUTHOR
Though technically insolvent, the GSEs will be bailed out to save the mortgage market, not shareholders.
FRIDAY, JULY 11, 2008
UP AND DOWN WALL STREET DAILY
Failure Is Not an Option
For Fannie and Freddie
By RANDALL W. FORSYTH | MORE ARTICLES BY AUTHOR
Though technically insolvent, the GSEs will be bailed out to save the mortgage market, not shareholders.
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THE GOVERNMENT OWNS FANNIE MAE AND FREDDIE MAC, only shareholders don't know it yet. That's one wag's assessment of the fate of the government sponsored enterprises that provide the lion's share of mortgages of American homebuyers, and it may not be far from the truth.

The Wall Street Journal reports federal officials are putting heavy pressure on Fannie (ticker: FNM) and Freddie (FRE) to raise significant capital to support their crucial role in the mortgage market. The New York Times, meanwhile, reports that the Bush administration is mulling a plan for the government to take over the GSEs if their problems worsen.

In either case, common equity holders' stakes would be diluted or perhaps wiped out as the public functions of the GSEs are given primary importance. It's not for nothing that Freddie stock has lost 45% of its value just this week while Fannie's shares have been marked down 30%.

Adding fuel to this funeral pyre was the assertion by William Poole, the former president of the Federal Reserve Bank of St. Louis, that Fannie and Freddie were "insolvent," according to Bloomberg News. That is, if their mortgage assets were marked to the current depressed market values, their liabilities would substantially exceed those assets. Freddie's net worth was negative $5.2 billion at the end of the first quarter, he said. Fannie's net worth may be negative as of the end of the second quarter, he added.

"Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer," Poole asserted in a Bloomberg interview.

While that may be financially true were Fannie's and Freddie's assets to be liquidated tomorrow, the political reality -- for better or worse -- is that the Treasury and the Fed will do whatever it takes for the GSEs to continue to function. That means maintaining their access to borrowing, not necessarily protecting equity holders' stakes. For those who doubt that, review the Bear Stearns rescue, in which shareholders got a small fraction of what their stock had fetched just days before the crisis reached its crescendo in mid-March.

Part of the most recent pressure on Fannie and Freddie relates to a change in an accounting rule that, were it applied to the GSEs, would potentially force them to raise $75 billion in new capital, according to a Lehman Brothers. So massive are the sums, the Lehman analyst emphasized, is that it would be unthinkable that such a requirement would imposed.

This accounting rule would force the GSEs to put currently off-balance sheet liabilities -- such as the guarantees on their mortgage-backed securities -- onto their balance sheet, resulting in the need to raise those vast sums of capital.

This controversy is a "red herring," assert JPMorgan Chase analysts. "We think that accounting changes, absent real economic impact, ought not to be material for decisions related to capital."

The negative net worth of Fannie and Freddie are legitimate subjects of concern, the Morgan analysts continue. But they add the GSEs have specific mandates to stabilize the home-loan market, which requires them to be able to acquire large amounts of mortgage assets when the market turns bad. Treating them like hedge funds and forcing them to mark everything to market would go against that mandate, they point out.

Furthermore, liquidation values of Fannie and Freddie ignore the worth of their future income streams from those assets, which they estimate at about $4.5 billion annually. Based on a simple assumption of a 10% cost of capital, the present value of those streams would be $45 billion.

Be that as it may, with the housing market in freefall, the government can't afford to let the GSEs fail. Not only do they own or guarantee about half of the $12 trillion in U.S. mortgages, Fannie and Freddie securities have become major holdings for foreign central banks that, like the rest of the market, have come to expect the federal government to stand behind those securities.

The impact of a failure of Fannie and Freddie, though technically insolvent, is beyond imagining, far greater than the bankruptcy of a Bear Stearns. For that reason alone, such an eventuality is unthinkable.

Comments: randall.forsyth@barrons.com