The Fannie and Freddie Government Makeover

Conventional Wisdom

Conventional wisdom would seem to indicate that Fannie Mae and Freddie Mac being put into conservatorship by the government is an ominous sign and ‘bad’ for shareholders, taxpayers and the overall economy.

Lets see, Fannie and Freddie’s (remaining) shareholders now own stock that is worth as much as a copy of the New York Times Sunday edition (check) and the American tax-payer will foot the bill to the tune of tens of billions of dollars (check, although this appears to be far less expensive than letting the two GSE’s and the industry spiral downward). The overall housing economy is now doomed…not necessarily.

Could You See it Coming?

First things first, I believe this was all a bit contrived and foreseeable if one read between the lines and canceled out most of the sensational mainstream media noise surrounding the two mortgage giants fall from historic highs.

It started here with a ‘butterfly flapping its wings half-way across the world’ in late January…

…Alison Utermohlen, senior director of government affairs for the Mortgage Bankers Association, asked FASB (Financial Accounting Standards Board) to cut lenders some slack on the accounting for impaired mortgage loans that they hold on their balance sheets. She asked the board for guidance that would permit lenders to use an easier accounting standard to measure the losses on loans that they are likely to modify to avoid default and foreclosure…

…Based on detailed questions posed by FASB (Financial Accounting Standards Board) to Ms. Utermohlen (to which she was responding), the board seems skeptical. For one thing, the simpler FAS 5 analysis would result in smaller impairments for the lenders. Under that standard, unless lenders expect not to recover the loan principal from borrowers, they don’t have to book an impairment. The more detailed cash flow analysis involved in FAS 114 would result in losses from interest rate modifications on the loans that many banks are expected to make. Accounting analysts favor the more detailed analysis. “This situation is what FAS 114 was written for,” said Marc Siegel, head of financial research and analysis at RiskMetrics and a member of the Investors Technical Advisory Committee to FASB. “Investors deserve the right information.”

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What Does That Mean??

Interpretation:  Lenders, including the GSE’s, were/are now subject to more conventional accounting practices…not good for the quarterly reports that Wall Street investors read and act on like annointed scripture.  Prior to this change lenders could effectively bury certain losses that other entities must report to their shareholders.  Going forward with conventional accounting guidelines, financial reports from lenders went from looking OK to insolvent almost overnight.

On July 10th 2008 William Poole, former St. Louis Federal Reserve President told Bloomberg in an interview:

Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae’s assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.

Fannie and Freddie stock was now akin to Enron 2.0; value evaporated almost overnight as ‘the real numbers’ surfaced and brokers began dumping the paper.  On July 11th, one day after Mr Pooles comments, trading volume of Freddie Mac and Fannie Mae stock exceeded 800,000,000 shares…almost 100x normal activity…and their value plummeted.

The Options Become Clear

It quickly became apparent that the mortgage GSE’s were going to have to consider raising substantial money or entertain a government bailout.   The prospect of raising money meant further stock dilution to remaining share holder, not too appetizing, and the sell off continued.  So, it’s a mess and the fallout must be cauterized…

Here we are, almost 9 months after the butterfly flapped its wings, The Government is stepping in.  Bad news right?  Maybe, maybe not.  It’s a radical move to say the least, yet could pull the housing and mortgage market out of the credit crunch and alleviate alot of downward pressure points.

“Government Takeover”

Strip away the language of ‘Government Takeover’ (that’s normally bad, mmmkay) and look closer at what now becomes possible in the short and long term for the housing sector in general and the individual homeowner.

There are potential benefits:

• Lender balance sheets will be cleaned up and thinned out.
• Mortgage rates and fees should get cheaper as a result.
• Mortgage paper will be turned into Federal paper, establishing much needed confidence from foreign investors.  Its a global market, keeping foreign investment money flowing through our economy is vital to its existence in 2008 (and going forward).
• Federal paper will allow borrowers to potentially ‘work out’ their delinquent loans with far more flexibility than they could with lender owned mortgage paper.

Loan ‘work-outs’ were/are generally not in the interest of lenders, especially those who’ve retained mortgage servicing companies or run the divisions internally, since these profit centers are paid to keep homeowners in their current situation and/or handle the foreclosure process.  If the business model is to keep borrowers making payments they can’t afford and/or pushing them into foreclosure, well its easy to see where the misalignment of objects and conflict of interests arise.

The government can effectively work with homeowners to restructure payment terms any way they see fit, keeping more people in their homes, substantially reducing the number foreclosures that have fostered the rapid depreciation in many housing markets around the country.

• Reduction of Wall Street volatility in what has historically been a stable segment of the bond market.  Consumer confidence needs to be restored to the mortgage market, volatility and consumer confidence usually don’t coincide with each other.

Many speculators made a lot of money by short selling Fannie and Freddie’s stock, accelerating their devaluation.  The SEC put a stop to this in mid July 08, by then the damage (or rewards) had been realized.  Months late and billions short(ed)

Contrived?

There of course is potential downside as well, most notably the governments propensity to weild its power in the direction of the lobbyist with the biggest check book.  As stated above, this all appears to be contrived and am so looking forward to seeing the details of how this all plays out.

How does this effect the wholesale market and the small to mid size broker or banker businesses?  Hrmmmm…

Its the end of an era for Fannie Mae and Freddie Mac, au revoir…