Bailout Bingo

The aggressive and dramatic government intervention of the nation’s two largest mortgage finance companies brings with it a foregone conclusion to the 2008 game of Bailout Bingo. The music did not stop due to any specific event, rather Treasury Secretary Henry Paulson was forced to acknowledge that without government help, credit and equity markets would be left twisting in the wind, or worse. So now that the bailout of Fannie Mae and Freddie Mac is official, it’s time to break down the plan and identify the winners and losers.

By placing the GSEs into “conservatorship,” the government is basically allowing them to complete a much-needed reorganization where they will be recapitalized. While the initial commitment by the Treasury is $1 billion, Paulson has committed as much as $100 billion to each company to provide a backstop in capital shortfalls. Under the terms of the plan, the government will be able to buy the companies outright at a small cost. The structure that will enable that process includes:

· The plan does not eliminate the common and preferred shares of either institution, but the companies will stop paying dividends on existing common and preferred shares. In essence, common stockholders will likely be wiped out eventually and preferred stockholders will take a massive haircut on the value of their shares.
· Senior Preferred Stock will be issued to the government, which will take precedence over all other types of equity.
· The Treasury will purchase $1 billion of preferred stock from each GSE. The stock will pay a dividend to the government of 10%, which can rise to 12% if either company misses its dividend payments.
· The Treasury will receive warrants that will entitle it to ultimately own 79.9% of each company.
· The government plans to buy significant amounts of mortgage-backed securities on the open market, beginning with the purchase of $5 billion worth this month.
· Beginning on March 31, 2010, the GSEs will pay what is essentially a management fee to the Treasury for all of its past efforts. The fee may be paid in cash or in additional issues of preferred stock.

Beyond the capital restructuring, the top brass at each company is OUT, replaced by the Federal Housing Finance Agency (FHFA). Two veterans of the industry will be brought in to run the companies during the reorganization. The new CEO of Fannie will be Herbert Allison, Jr., the former chairman of TIAA-CREF, succeeding Daniel Mudd and David Moffett, the recently-retired CFO of U.S. Bancorp, will replace Richard Styron of Freddie. Suffice to say that losing their jobs is not close to what should happen to these two, whose “stewardship” has been laughable. If they are able to collect their severance, retirement benefits or deferred compensation, it would be a travesty. Mudd has already taken home $12.4 million in cash since taking over Fannie in 2004 and Styron has pocketed $17.1 million in pay and stock options since 2003. That seems to be plenty, thank you very much!

Winners and Losers:
So who wins and losses under this vast plan? Let’s start with the Biggest Losers—US! Yes, the good ol’ American taxpayer is going to be on the hook for all of this debt, most of which was not our doing. It is unclear how much this clean up will cost—early estimates put the number at $200 billion, but until the housing market finds a bottom, we will not know the real damage. Until then, sit tight and try to imagine how the next administration is NOT going to raise taxes.

The common and preferred stock holders are going to lose—big time. Of course, this point seems silly now—common shareholders have already lost approximately 90% over the past year. This group includes some storied value mutual fund managers, like Bill Miller of Legg Mason, David Dreman and Martin Whitman, all of whom held and in some cases, increased, their holdings in both Fannie and Freddie. Among the preferred shareholders are some fairly large regional banks, like Sovereign Bancorp, which holds approximately 13% of its tangible capital in GSE preferred stock, and Midwest Banc Holdings of Illinois and Gateway Financial Holdings of Virginia and North Carolina.

The next loser is the free market. I don’t want to get all crazy on this one, because once the system went so completely awry, there were not a lot of good choices. Again, let’s not kid ourselves: the owners of Fannie and Freddie made a ton of money on the way up and now the government is socializing their losses. Of course, Wall Street, the bastion of “heads we win and tails you lose”, is happy with the deal, because it allows the institutions to continue operating. By keeping Fannie and Freddie afloat, the government will likely restore over a billion dollars worth of fees to the Street, which should help the big firms claw their way back into the black.

Other winners include those who are shopping for a mortgage (it is estimated that the plan will allow mortgage rates to decline by .25% or so); Bill Gross, the CIO of PIMCO, which owns $500 billion worth of mortgage-backed securities (wasn’t that Bill who last week squawked that the US had to bail out Fannie or Freddie or risk a financial system melt-down?). Yesterday, US equity owners were winners, although the reaction could be a one-day wonder, but heck, in this environment, we’ll take it! Finally, the former Fannie and Freddie CEOs, as noted above, have reaped the most amazing benefits, even as the music stopped in our game of Bailout Bingo.