Fannie and Freddie

Author: David Kotok, Post Date: July 11, 2008
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Let’s try to sculpt some of the fog swirling around the Fannie Mae and Freddie Mac (F&F) issues.  First some facts:

1. Under present rules the Fed is already specifically authorized to purchase F&F debt for its own account. view history No change in rule or law is needed.  As of the most recent Fed Reserve report (Thursday, July 10) the Fed’s holdings were zero.

2. The Fed already accepts F&F as collateral for Discount Window lending and TAF lending.  The same is true for all the debt of any of the Government Sponsored Enterprises (GSE).

3. The Fed does not lend directly to F&F at the present time.  F&F are not primary dealers.  For a list of the primary dealers, look at the NY Fed website.  You will not see F&F.

4. The Fed could make F&F a primary dealer at any time.  It can invoke the same emergency power that it used in the Bear Stearns transaction and in the subsequent authorization of direct lending to the remaining primary dealers.  At the moment the Fed has no reason to do this.  F&F are not important agents for the Fed when it engages in open-market operations.

Now we offer some opinions:

F&F will not be allowed to default on their direct outstanding debt.  The systemic destruction would be global and enormous.  F&F paper is held by institutions worldwide.  And it is a legal investment and holding for nearly all state and local governments in the United States.

Equally true is the status of the debt that F&F has guaranteed.  The government will not permit default on the mortgage-related securities pooled and then resold with an F&F guarantee.  Furthermore, there is no imminent threat of default.  The payment stream from the more than $5 trillion of mortgages is mostly current and has a reasonably good performance history.  In addition, F&F are functioning agencies.  They have liquidity and market access.  Default by F&F is very unlikely.  Those who compare F&F to IndyMac’s seizure are mistaken.

Solvency and the need for capital is another issue.  If one puts the guaranteed mortgages on the balance sheets of F&F, they will have absolute and certain capital inadequacy.  The estimates vary but seem to center at about $50 billion.  F&F face an impossible task if they have to raise that amount by conventional means in this market climate and with the intensely negative sentiment circulating about them.  Their capital is thin to start with although it is conforming in accordance with the rules of their federal regulator.  The now infamous accounting rule change would render them technically insolvent, as former St. Louis Fed President Bill Poole correctly contends.

In sum, we are not worried about a default in F&F debt.  We hold positions in mortgages guaranteed by F&F and some small positions in their debentures and notes.  The widening of credit spreads on all GSEs has made them attractive for certain portfolios.

Common shares of F&F are another matter.  We value them at near zero.  In the Bear Stearns event we saw affirmation that the federal government had no sympathy for equity investors even as it preserved the rights of debt holders and counterparties.  We believe the same is true for F&F.  The stock market thinks so, too.  That is why the equity value of F&F has been decimated.  We have avoided F&F shares and have been selective in the use of broad ETFs where they are part of a large assemblage of stocks

The preferred shares are a tougher issue for investors.  They are trading at about 70 cents on the dollar in a thin market.  We believe they are at risk if some restructuring of F&F is undertaken by the federal authorities.  The balance sheet construction and the concept of a preferred are clear, and investors should not be deluded into thinking otherwise. 

A restructuring of F&F could take many forms.  Some of the possibilities would eliminate the claim of to the preferred shareholder. Other forms of reorganization would preserve it.  This outcome is unpredictable. There is risk in this preferred security.

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