Cover Your Fannie...and Freddie too

“IT MAY BE CURTAINS SOON FOR THE MANAGEMENTS and shareholders of beleaguered housing giants Fannie Mae and Freddie Mac. It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses.”- Jonathan Lang in Barron’s August 18, 2008

And so began phase two of the Fannie and Freddie “deathwatch” on Wall Street. Perhaps you thought that the crisis over the two government-sponsored enterprises (GSEs) had passed in July when the Treasury Department stepped in and quelled frayed nerves. The Barron’s article highlighted the fact that the continuing decline in real estate values has led to a spike in mortgage delinquencies and foreclosures, which in turn have severely damaged the balance sheets of both Fannie and Freddie.

While the two companies may be adequately capitalized according to their regulator’s current definition, according to Barron’s, “On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.”

While both companies maintain that they have enough money to weather this storm (remember when Bear Sterns said the same thing a week before it practically filed for bankruptcy?), it has become clear that the GSEs need to raise cash and fast. But who in his right mind would take the plunge right now? Two weeks ago, the companies added another $3.1 billion in losses to the $11 billion they had already reported in recent quarters. Talk about throwing good money after bad!

When in doubt, you can count on good ol’ Uncle Sam to provide the big-time safety net. Last month, Congress gave the Treasury Department the authority to lend money to the firms or take an equity stake in them. It is estimated that the federal government would have to pump approximately $20 billion into each company, possibly through a guarantee rather than through a direct injection of capital. Legislation passed last month allows the government to do so to stabilize financial markets and to prevent disruption in the mortgage industry. Barron’s noted that a government bail-out might “take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends.”

Time is ticking for Fannie and Freddie but one thing is for sure: investors are convinced that the government will take steps to end the patient’s suffering. We can only hope that the end is swift and as painless as possible.