Monday, July 14, 2008

The Bailout of Fannie and Freddie: The Beginning of the Beginning

Please forgive any punctuation or spelling errors you may find here. I continue to have trouble with the edit function of my blogger account. I will have things back to normal shortly.

Fannie Mae and Freddie Mac appear to be headed toward a rendezvous with something that John Maynard Keynes would advocate -- a bailout. Within days they are likely to be getting a helping and "visible hand" from Uncle Sam in the form of government loan guarantees and capital infusions to strengthen their capital bases. At issue is their net capital -- they don't appear to have enough of it to carry the trillions of dollars of mortgage loans that the two hold between them, especially when housing prices are falling and defaults are rising. As big and as powerful as Fannie and Freddie are, they could not stand as the savior of the housing industry. Only the US government can do that, but Fannie and Freddie will play an important role in the bailout of housing. They will be the conduits and the facilitators of the government's largess in cleaning up the housing debacle. Private and public financial types were in the news over the weekend discussing the Treasury Department's deeper intercession into the housing quagmire. Treasury Secretary Henry Paulson has announced that he will ask Congress to approve a wide-ranging package of loans and equity commitments to the Fannie Mae and Freddie Mac. I have had a growing worry that if the government did not step in to assist Fannie and Freddie that the negative momentum that has ensnared nearly all financial institutions may have propelled both government sponsored enterprises into a technical state of default, whether or not the financial statements would deem it fair or equitable. The banking system largely remains frozen, as banks shore up their own capital ratios with the spreads they can earn from borrowing short-term Fed Funds and investing in longer-term higher yielding debt. Almost all lenders surveys are now indicating a significant tightening of lending standards. Thus, Fannie and Freddie have been left as the home mortgage makers of last resort, and the only windows truly open to all comers. The possible demise of Fannie and Freddie was simply too big a risk for the government to take. They had to act. They had to give up on Adam Smith's invisible hand, for Keynes' visible hand. This intrusion into the fine points of capitalism will be debated ad nauseum, but though I am the staunchest of believers in free markets, I called for this move weeks ago, when I said that before the housing ordeal was over, the United States Government would be investing in mortgages. That was the only way I could see then, or now to stop the cascading real estate snowball from plowing through every bank in the country. Now the government is on the inside. Through an equity role with Fannie and Freddie they will be able to see the real numbers, not play peek a boo with enterprises that are trying to hide their true financial conditions. I want to speak to the different asset classes that Fannie and Freddie have in the market and their relative degree of risk associated with these changes. The list is not exhaustive. It is just the main body of securities that trade everyday. 1. So-called Sovereign Agencies, or Debentures: These are a staple in the investment world and a product that we use broadly. They have been rated AAA for years and continue to be. These Agencies have what is called an implicit backing by the government that just became explicit. This is good news.

2. Collateralized Mortgage Obligations guaranteed by Fannie or Freddie: These, too, just got a lot safer, though they were already had a high degree of safety even before this move because of their high quality collateral.

3. Preferred Stocks: The devil might be in the details here, but as I read Mr. Paulson's plan, Fannie and Freddie's preferred stocks should get and immediate boost. They just got a lot safer because there is now little likelihood that Fannie and Freddie will fail.

4. The wild card is the common stock: I think that was the reason these two stocks were so weak on Friday. If the government is going to take an equity position, it will be very dilutive to current shareholders if it looks like the private equity deals. Having said this, the stocks might pop a little higher if it looks like the deal will be approved quickly.

To me it was inevitable that the government would have to get into the mortgage business to turn around housing. I am very hopeful that in doing so, they have truly begun the beginning of a turn around in real estate.