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Paulson decides the fate of FRE/FNM: Conservatorship

So Freddie Mac and Fannie Mae have been “converved” – or whatever it takes to be in a conservatorship. Some of my notes, from Paulson’s speech are below.
But first, note that there are three things at stake here.

  • Debt, which is what the GSEs (Freddie/Fannie) take from external entities against their assets. GSE bonds are debt. Any note to senior or subordinated debt means debt in their order of liquidity preference (i.e. senior gets first call on the assets in case of bankruptcy versus subordinated.
  • Preferred shares – these are like ‘debentures’ in India. They carry a coupon rate of interest – which necessarily gets paid out unless there is a crisis.
  • Common shares – get traded on the exchange.

In case of a big problem, usually erosion of net worth hits Common first, Preferred next and then suborodinated and Senior debt. Let’s now see FRE/FNM’s “takeover” in this context:

  • Conservatorship means the GSEs aim will be to conserve capital, not increase return for shareholders. This can mean anything in reality but let’s take it at face value for now. The CEOs will be fired but they’ll stay till the transition is done.
  • Common stock goes to zero or close. The government gets a fresh issue of 80% of common – everyone else is diluted and given that shareholder interests are not paramount, and the first hit will be taken by Common in case of net worth erosion, Common is toilet paper.
  • Preferred – well, it will trade, but it is second to take a hit. Let’s see now – the GSEs have about 80 bn in capital, to $5trillion of mortgage loans covered. The current “seriously delinquent” rate is about 2.5%, which is mortgages that are 90 days or more late or in foreclosure. If the GSE coverage is about 2 trillion each, that’s a $50 bn hit if they get hit with the same statistic. Yes, some of this may be farmed out through MBS, but I would assume a substantial net worth erosion is likely – and that will take out preferred. In any case, all dividends to preferred are stopped immediately, so there’s not much point to holding them longer.
  • Debt: Should be as secure as treasuries. Note that if the GSEs have insufficient money to pay back, the treasury will cover it as and when needed.
  • The GSEs will expand their operations, at about $20 bn a month, till Dec 2009. I don’t know what this means. I found an August 2008 presentation at Freddie that showed new purchases of $43 bn a month for the first six months of the year. So this may be a limited continuance of business.
  • But they must not exceed $850 bn of retained portfolio by March 2009. FRE has about $792 bn as of Aug 08. So they can’t even do $20 bn per month.
  • And after Dec 2009, they have to pare down coverage by 10% a year.
  • The treasury will fund all debt payments, and will get preferred stock in return. The initial input is $1 billion, at 10% a year.
  • The Treasury also buys MBS issues by FRE/FNM. Very interesting. This is to take off the load from the GSEs, and the assumption is that the Treasury will hold to maturity.
  • There’s a huge credit facility in the interim as well, as a backstop for liquidity.

This provides clarity to debt holders. Stockholders are screwed.

But the treasury is taking on a lot of risk. First, they take preferred stock in an entity that will not grow much, and therefore employ taxpayer money in a dead avenue. But the alternative must hurt more – i.e. letting them fail and having Americans face the consequence of reduced loan availability and a financial depression.

Second, they buy MBS. This can promote bad behaviour. If the other banks decide that oh, the US government will buy our junk, they can sell it to FRE/FNM, who will package and sell to the treasury. Yeah, there are supposed to be checks and balances, but after all that has happened they expect us to believe that?

There is no mention of regulation tightening. Of bringing all derivatives to an exchange, of how to handle mark-to-market, or of any level of capital minimums or whatever.

Overall, this is like saying, listen, we screwed up in the past, ok? So we’ll fund this crap. Going forward, all bets are off. We can’t say we’ll fund more mortgages because FRE/FNM won’t be buying a heck of a lot more. We can’t allow FRE or FNM to provide unlimited depth to the housing market. (Which btw, is about 20 trillion $, of which 10 trillion is debt. And FRE/FNM account for some $5 trn of that. And around 65% of that figure is loan – so a net debt of $3 trillion or more, which is three times India’s GDP)

So this is a short term plus in that it provides clarity of some sort to how the PAST gets sorted out. Expect a rally everywhere, and for reasons from the moon to Belfast. Now the future is not quite addressed, so my theory is that everything is hosed anyhow. The US housing market has much more of a decline coming up given they don’t even have FRE/FNM to do unlimited support. Prices aren’t yet down enough to call it “affordable”. Recession impacts are not yet in. This is just another day, just another random event. Somewhat like medication given to a dying man…the idea isn’t to keep him alive, it’s just to ease the pain.

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