Fannie and Freddie

The title need not be too clever on this one. In case you have been under a rock for the last week, on vacation, or at the Calgary Stampede taking in some sweet country tunes, this has been an incredible week on the markets. We've seen oil drop from record highs by more than $10 a barrel, only to shoot up again to new records (thanks a bunch Iran and Nigerian rebels). We've seen incredible volatility in both the credit markets (see London on Tuesday for further reference), and astounding drops in equity values across the board in financials, consumer cyclicals, and well, anything with any exposure to the rapidly souring economy. It hasn't been too positive. The sentiment on the street is almost universally bearish.

By far, the biggest story of the week, and potentially one of the bigger stories of the year is the rapid and almost unbelievable fall in the share prices of Fannie Mae and Freddie Mac. The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) have seen their share prices plunge this week. Fannie closed at $9.96 on Friday, while Freddie closed at $7.75. They opened the week at 19.76 and 15.08 respectively. Their 52 week highs have been $70.57 and $67.20 - an unbelievable erosion of shareholder value. These are the lowest values seen in 16 years.

Fannie and Freddie have been mortgage industry stalwarts since 1968 and 1970 (when the became private corporations - Fannie had been around since 1938 as a government-owned entity). Fannie and Freddie have the unique distinction of having the implicit backing of the U.S. government, and hence, have been thought to be immune to the more wild swings in the market. As a result of this backing, they have been historically able to borrow at very low rates over the benchmark Treasury (about a 1/8th spread over Treasuries). Fannie and Freddie's bonds now yield about .78% over Treasuries - the spread has doubled since last summer. The CDS on Fannie and Freddie has jumped about 20% this week alone. The 5 years now trade at about 78 bp a piece. That is, it costs $78,000 to insure $10m of notional per year.

Fannie and Freddie were created to ensure easy access to home mortgages. The Congressionally-chartered institutions have become critical pegs in the financial system, and currently own or guarantee about $5.2 trillion worth of U.S. home mortgages. That is actually half of all US mortgages currently outstanding. Now, as has been well documented, the subprime and housing crisis that has hit the U.S. in the past year has reduced the much of the value of the assets on Fannie and Freddie's balance sheets. Simply put, many Americans are not keeping up on their mortgage payments, and Fannie and Freddie are starting to see less inflow of cash. To make matters worse, the value of the homes if seized in foreclosure has fallen dramatically from a few years ago. So the two companies are getting hammered at both ends. It's not a pretty picture to say the least.

Thus, with the value of assets on the balance sheet rapidly eroding, it's become clear that FNM and FRE will have to raise more capital. They have already recorded combined losses of about $11 billion this year. That includes losses realized on the sale of foreclosed homes, provisions for future loan losses, as well as the downward revision of the value of mortgages and related securities. These losses will most definitely be added to in the future. Fannie has already issued capital to the tune of $7.4 billion in April, while Freddie is in the process of raising about $5.5 billion. One major problem facing the two companies right now is that they have not been required to hold much capital in the past due to the fact that regulators never fathomed a situation of widespread defaults (like this) occurring. With every massive drop in the value of the common shares, it becomes harder and harder to issue new shares, due to the effect of dilution.

There are a number of possibilities for Fannie and Freddie. One is that the Fed might purchase a bunch of the mortgages from the company, thereby alleviating some of the immediate pain, and shifting the burden to taxpayers. Another, more drastic option, would be to the firms into conservatorship, which would transfer ownership directly to the government. Still another option includes an infusion of private equity capital; however, this is less likely given the huge exposure FRE and FNM have to the housing market, and the tight regulations by which they must abide. Although these options would be explored as a last resort, it's becoming increasingly likely that there will need to be some form of government intervention. The downside risk of these two behemoths failing is stunning, and regulators, politicians, and pundits have all agreed that the government cannot let Fannie and Freddie fail.

One thing that Hank Paulson and the government does not want to do is incentive risk-taking. They do not want to create a moral hazard as they arguably did in the case of Bear Stearns (although Bear shareholders lost so much money, it can be argued that no moral hazard was really created). The implicit guarantee by the government has created an awkward situation, as shareholders have long believed that the companies will be rescued in a crisis, which has allowed the two companies to borrow at very favourable rates. Many would argue that it is these same profit-oriented investors who should feel the brunt of the pain now, as they for years have enjoyed steady dividends and capital appreciation provided by Fannie and Freddie.

In other the-world-might-or-might-not-be-ending news, the government on Friday announced that it was seizing IndyMac Bank. It is the 3rd largest bank failure in U.S. history. The collapse is expected to result about $4 to $8 billion in costs for the FDIC (Federal Deposit Insurance Corp). This could constitute about 10% of the fund's $53 billion deposit-insurance fun. Funny/sad story on this one. A few days ago, Democrat Chuck Schumer sent a letter to the Office of Thrift Supervision (the regulator) questioning the solvency of the bank. Of course, that's not the wisest thing to do in a situation like this, and investors promptly withdrew $1.3 billion in deposits from the bank. Schumer's comments, though, were only the large straw that broke the camel's back. IndyMac has been in trouble for months. The bank specialized in Alt-A mortgages, which are given to people who don't need to fully document their incomes or assets. Surprise, surprise, this didn't turn out so well for them. The bank will be reopen on Monday. The FDIC will provide about $100,000 per depositor. About $1 billion of the deposits were uninsured, so about 10,000 investors will get the shaft. Long story short, add IndyMac to the list of institutions to get absolutely smoked as a result of the subprime crisis. There will be more to come.