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Fannie and Freddie: U.S. Government Takes Control

by: Edward Harrison September 08, 2008 | about stocks: FNM / FRE    

Edward Harrison

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The US government has finally stepped in to stop the bleeding. Fannie Mae and Freddie Mac, the two giant government sponsored enterprises have been taken into conservatorship and are now government property. As I consider this move a bankruptcy, I will add these two to my list of Global Banking Bankruptcies. These are by far the largest bankruptcies in US history and the move to shore up Fannie and Freddie is unprecedented. The move was widely anticipated and pre-announced by Barney Frank, chairman of the Congressional Financial Services Committee. However, this is still an enormous financial event that will have major consequences on financial markets around the world.

Fannie and Freddie make up half of the US home loan market. If this doesn't remind one of the Great Depression, then one needs to get in touch with what is really happening to the capitalist system.

Please see sources below for the multiple takes on this news.

The following are the main features of this government bailout. This is a wholesale nationalization of the entire US mortgage problem. Of particular note is the fact that the plan does not say what will happen after conservatorship, i.e. whether Fannie and Freddie will be nationalized permanently, re-privatized or liquidated. Also of note is the extension of a secured line of credit to the Federal Home Loan Banks.

  • The Treasury gets $1 billion of senior preferred stock -- with warrants -- representing 79.9 percent of Fannie and Freddie. The government receives 10% interest on its investment.
  • Existing shareholders will still be left with a share of the business but will pick up expected future losses before the taxpayer becomes liable. Obviously, shares in the two organizations are now worthless.
  • The US government will now have all voting rights and own 80% of the common stock on a fully diluted basis. Again, the equity of existing shareholders is now worthless.
  • Preferred shares have had their ratings slashed to junk, which is not a good sign for them. Bloomberg reports Gimme Credit analyst Kathleen Shanley as saying the takeover is "unambiguously bad'' for preferred shareholders who, along with holders of common stock, "will in all likelihood be wiped out."
  • US regulators are very concerned that five or size US regional banks may have outsized exposure to Fannie and Freddie preferreds and will have their capital wiped out. Look for regional banks to be very volatile on Monday morning in US trading. Gateway Financial and Midwest Banc are most exposed.
  • Sheila Bair, head of the FDIC said "across the industry, banks do not have significant exposure to GSE equity securities. Any negative impact will be narrowly focused only on a few smaller institutions." Nonsense. Don't believe a word of this. You have been warned.
  • Fannie and Freddie debt is expected to be backed by the full faith and credit of the US government.
  • Any capital shortfalls induced by losses incurred by either organizations will be made up by funds from the US Treasury. The treasury has received a blank check from the US congress and is authorized to make good on any sum to bail out losses at Fannie and Freddie.
  • As a result of this unprecedented move, Fannie and Freddie will be forced to reduce their relative size in the US mortgage market. The US Treasury has mandated that the combined Fannie/Freddie portfolio value "shall not exceed $850 billion as of Dec. 31, 2009, and shall decline by 10 percent per year until it reaches $250 billion." How the government intends to achieve this without the market seizing up due to illiquidity is beyond me. However, Bloomberg says "Fannie's portfolio was $758 billion at the end of July, and Freddie's was $798 billion."
  • The executives and Board of Directors of both institutions have been replaced. Herb Allison, a former executive at Merrill Lynch, was picked to head Fannie, and David Moffett, a former vice-chairman of US Bancorp, was selected to head Freddie.
  • However, the CEOs of Fannie and Freddie will make out like bandits even though they were effectively fired, the New York Times reports:

    Under the terms of his employment contract, Daniel H. Mudd, the departing head of Fannie Mae, stands to collect $9.3 million in severance pay, retirement benefits and deferred compensation, provided his dismissal is deemed to be “without cause,” according to an analysis by the consulting firm James F. Reda & Associates. Mr. Mudd has already taken home $12.4 million in cash compensation and stock option gains since becoming chief executive in 2004, according to an analysis by Equilar, an executive pay research firm. Richard F. Syron, the departing chief executive of Freddie Mac, could receive an exit package of at least $14.1 million, largely because of a clause added to his employment contract in mid-July as his company’s troubles deepened. He has taken home $17.1 million in pay and stock option gains since becoming chief executive in 2003.    

  • The US government is not just nationalizing Fannie and Freddie - The Treasury is extending secured a credit line to all the Federal Home Loan Banks. Any loans would be backed by Fannie Mae and Freddie Mac mortgage paper.

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This article has 3 comments:

  •  
    Sep 08 02:35 AM
    Another apt reminder from Thomas Jefferson...
    "I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale. "
    Reply
  •  
    Sep 08 03:24 AM
    Good article clarifying the complex issues. For the average investor not time to get excited yet, let the dust settle? The article says this bailout reminds one of the Great Depression, a remark not to be taken lightly.
    Reply
  •  
    Sep 08 08:11 PM
    The game is fixed. Get it? The richest families plant their boys in the plum jobs; the boys fail, and exit with the money. The game is fixed. Get it?
    Reply
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