Fannie Mae and Freddie Mac: A Damage Report

Talk of a government bailout of Fannie Mae (FNM) and Freddie Mac (FNM) has reached a crescendo recently, including market rumors of a surprise government recapitalization of the mortgage finance companies over the Labor Day weekend, which the Treasury Dept. has denied. In view of a potential rescue of the troubled firms , it may be time for a damage report. Here is an assessment of how much wealth holders of the agencies' stocks and debt have lost since the housing crisis began to wreak havoc on the government-sponsored enterprises—and the potential financial damage that may lie ahead for investors.

Losses for holders of the GSEs' common stock are straightforward—roughly $100 billion in market cap has vanished since the start of 2008, with Fannie and Freddie shares down about 85% over the past eight months. Losses for investors in the mortgage giants' preferred shares, which continue to pay hefty dividends, are harder to calculate. Fannie and Freddie each have multiple issues of preferred stock, which vary based on initial share price, number of shares issued, and dividend rates. For example, all of Freddie Mac's preferreds issued in 2007 were priced at $25, while those issued in prior years were priced at $50. The share counts vary, however, and the preferreds now trade at various prices.

Here too, the losses have been significant. Freddie Mac's most recent preferred shares, issued on Nov. 29, 2007, at $25, closed at $12.87 on Aug. 27, translating to a loss of $2.91 billion for those who bought them at the original price.
The Intervention Question

Ultimately, the losses to shareholders will be determined by how Treasury decides to treat the companies' equity if it intervenes to recapitalize the agencies. The market for preferreds is pricing in the risk of some form of government intervention, with some issues trading for as little as 50 cents on the dollar, compared with around 92 cents on the dollar at the end of June, says Sam Caldwell, an analyst who covers regional banks for Keefe, Bruyette & Woods (KBW).

It's mainly individual investors who have borne the brunt of the losses on the agencies' common stock, but regional banks, insurance companies, and other financial institutions have taken the hit on the devalued preferreds, and those with a substantial portion of their capital tied up in these securities can ill afford to have all their value wiped out under a government bailout. Fannie and Freddie preferreds account for at least 32% of the tangible capital held by two regional banks—Gateway Financial Holdings and Midwest Banc Holdings—and 5% or more for a slew of others, according to an Aug. 25 report by Caldwell.

While he believes large-cap banks have limited exposure to agency preferreds, Caldwell found 38 banks with aggregate exposure of $1.3 billion, and 81 other banks that said they didn't hold any preferreds.

A day of reckoning for losses on the agencies' preferreds could be Sept. 30, when firms will need to mark down the value of the assets on their balance sheets to fair market value. A few regional banks have already taken writedowns for other-than-temporary impairment on the preferreds they hold. Earlier this week, JPMorgan Chase (JPM) said the value of its preferreds has been halved to $600 million this quarter and hinted it will take a charge on those assets when it reports third-quarter earnings.

"What's good for JPMorgan should be good for the rest of the industry," says one analyst who covers regional banks and asks not to be named.
Writedowns for Many

The accounting firm KPMG has been more aggressive about directing clients to write down the value of impaired assets than some of its peers, so all financial institutions that use KMPG as their auditor would be expected to take writedowns at the end of September, says Caldwell. And certainly, if the preferreds continue to trade underwater and the government hasn't made any decision on a bailout, all firms that have invested in the agencies' preferreds would have to take a writedown by the end of this year, he adds.

At least the preferred holders are still getting the dividend they expected when they bought the shares. Earlier this month, Fannie's board slashed the quarterly dividend on its common stock to 5 cents from 35 cents a share to preserve $1.9 billion in capital through 2009. Freddie sliced its 50 cent quarterly dividend to 25 cents in late 2007.

The implications for debt issued by the two agencies are harder to figure.

The housing bill that President Bush signed into law at the end of July made explicit the federal government's guarantee of $5.2 trillion in U.S. mortgages backed by Fannie and Freddie, so that debt is presumably free of risk.

Although no one has any doubt that the debt Fannie and Freddie issue to finance their own operating costs, all of which seems to be actively traded, would be made whole, the securitized mortgages the agencies have packaged and sold to investors are a different story, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management, based in Salem, Mass.

"The fear here is that the market participants—most of the stuff was purchased by foreign central banks—will see the risk and stop purchasing it. If that happens, then [mortgage] rates would rise [substantially]," he says.
Guaranteed to Guarantee

If the government does intervene, bondholders' principal and accrued interest would be protected, but that doesn't mean they would be able to trade the debt easily, he says. Strategists agree that the Treasury wouldn't risk the sanctity of a global banking system by not guaranteeing that debt.

Fannie and Freddie need to refinance about $250 billion in debt in September, and the market will be watching to see how successful they are. Neither agency has had difficulty attracting subscribers to its monthly bond auctions, which makes Larkin think they won't have a problem rolling over the debt that matures next month.

Outside of a bailout, the agencies' subordinated debt would be at risk only if the credit ratings were downgraded to junk, which would force many financial institutions to sell their holdings at big losses, says Larkin. In an Aug. 18 story, Barrons estimated that there is a total of $19 billion of GSE subordinated debt that would be at risk under a government bailout.

The ratings on the subordinated debt are hovering just above investment grade. On Aug. 22, Moody's Investor Service (MCO) lowered its rating outlook on the agencies' AA2 subordinated debt to negative from stable but affirmed their senior debt ratings at AAA. Moody's also downgraded Fannie's and Freddie's preferred stock ratings to BAA3 from A1, Standard & Poor's Ratings Services on Aug. 26 affirmed its AAA/A-1+ rating on Freddie's senior unsecured debt with a stable outlook but lowered the subordinated debt rating to BBB+, and the preferred stock rating to BBB- from A-, also placing those ratings on CreditWatch Negative.
Reason for Hope

Michael Wallace, global market strategist at Action Economics, says some of the subordinate debt holders still have reason for hope that Fannie and Freddie can successfully recapitalize on their own. If the government intervenes, though, "it's anybody's guess what anything will be worth."

Despite the increased chatter about an impending bailout, most analysts see no pressing need for one as long as the GSEs hold ample amounts of excess capital on their balance sheets. As of last week, Fannie's excess core capital—above the amount required by regulators—was $9.4 billion and Freddie's was $2.7 billion. And with $10 billion in mortgage paydowns a month, each company would be able to free up $1 billion of core capital every quarter if they opted not to reinvest these paydowns, according to a Citigroup report published Aug. 21. A point of further irony: Despite mounting foreclosures, Fannie's and Freddie's profitability has been improving lately with margins between their assets and their borrowing costs the widest they've been in many years, Citigroup said.

Larkin says it is highly unlikely the Bush Administration will do anything to damage the private-enterprise component of the GSEs.
"Political Football"

"The last thing [they] want to do is create another giant division of the U.S. government. That's why things are quiet now. This is a political football," he says. In addition, if the government makes a move that ends up harming the agencies, the Administration wold be chastised for making home mortgages less affordable.

Wallace at Action Economics disagrees. He believes Republicans don't like the quasi-governmental structure of Fannie and Freddie, which doesn't jibe with their view of free markets, and says if the government does take them over, it could just as easily dispose of them, change their mandates, or sell off their assets.

All told, the damage to the agencies' equity and debt investors is hard to quantify, but it will certainly run in the hundreds of billions of dollars. Dan Seiver, a finance professor at San Diego State University, provides one final bit of perspective: However much stock and bond investors stand to lose in the end, it will probably be dwarfed by the total wealth that American homeowners have seen evaporate since the credit crisis started—an amount he estimates will be in the trillions.