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A Tale of Two Markets


Digging into the prehistory of the crunch.

Editor's Note: The following piece was a collaboration with Minyanville professor Rob Roy and is the first piece in a 3-part series. Part 2 can be found here. Part 3 can be found here.

Fannie Mae (FNM), the largest U.S. mortgage finance company, slashed its dividend 86 percent after posting a loss three times analysts estimates, and said the worst housing slump since the Great Depression is deepening.
- Bloomberg, August 7, 2008

Freddie Mac (FRE), the U.S. mortgage finance company hobbled by record foreclosures, slashed its dividend at least 80 percent after posting a quarterly loss that was at least three times wider than analysts' estimates.
Bloomberg, August 6, 2008

I have spent most of my career concentrating on the credit markets. Perhaps it was a mathematical background that got me interested in credit and bond structure, but whatever the reason, this has been my focus. After that, despite a degree in Economics, I began to enjoy examining the macro-economic picture, particularly as the landscape began to change so drastically with the Greenspan-led Fed of the 1990's. This background in credit and macroeconomics is what leads me to the observations in this piece, and I hope you find them helpful if not a little disturbing about what is currently occurring.

The purpose of this piece is to describe the dichotomy between credit markets and the equity market (stocks vs. bonds). Many people like to say that the credit market is more rational than the equity market. True value seems to be more apparent and quicker in the credit market while the stock market is more of an emotional roller coaster driven by the forces of fear and greed. While I believe this to be true, I shall leave it up to you do decide if the argument makes sense.

What I do know, however, is that the debt and equity markets are telling distinctly different stories these days. Since I will put my money on the credit market (both figuratively and literally), I will explain below why I believe that particularly turbulent times lie ahead for both credit and equity markets.

The Fannie Mae/Freddie Mac Experiment

Fannie Mae and Freddie Mac have operated as Government Sponsored Entities (GSEs) for decades while also being public companies. You might say that they 'served two masters', both their shareholders and OFHEO, their regulatory body. Somewhere along the way, though, Fannie and Freddie lost their way.

Fannie Mae was originally created by the government of Franklin D. Roosevelt as part of his New Deal in 1938. Its purpose was to create liquidity and provide funding for homeownership. For about three decades, FNMA was the only game in town and provided the vast amount of mortgages in this country. But once its balance sheet grew large, the federal government decided to spin off this entity into its own private formation so as to remove their balance sheet from that of the US government.

When FNMA was spun-off as a public company, it stopped guaranteeing government issued mortgages, and that job fell to Ginnie Mae (GNMA). However, because FNMA was a virtual monopoly in the mortgage market, congress chartered a competitor in 1968 as a private company called Freddie Mac (FHLMC). So this was the birth of the mangled public/private mortgage montage we call the GSEs: regulated by the government, but chartered to compete with each other in the private marketplace. Only the government could create such a mangled mess from the start, but this was only the beginning.

In private enterprise, competition often sports the look of growth, and grow they did. As their balance sheets began to grow dramatically, their complexity grew. As a public company, the GSEs wanted to provide the greatest return for their shareholders, while attempting to stay within the guidelines of the federal regulator.

In order to provide this growth in earnings for their shareholders, they began to take on lower quality mortgages, and to trade derivatives against their portfolio of loans to control the risk. Eventually, this increased complexity made it so difficult that they couldn't report earnings for several years. As a result, OFHEO then put stringent capital surplus requirements on Fannie and Freddie until they could get their financial houses in order (excuse the pun).

But then a nasty thing happened when sub-prime mortgages began to default at higher levels and housing prices stopped their meteoric rise. Once this bubble burst, more than 250 mortgage originators went bust and/or closed their doors. This left the risk squarely in the GSE's court-they were forced to pick up the slack of other mortgage originators. In addition, many of the loans that Fannie and Freddie had purchased from these originators began to default at faster rates than anticipated as housing began to collapse and they began taking write-downs just like Citigroup (C), Merrill Lynch (MER), AIG (AIG), Lehman Brothers (LEH), Morgan Stanley (MS), HSBC (HBC), etc.

Now because they had to maintain capital surpluses due to their previous wrongdoings, these losses forced them to raise capital by coming to market with preferred stock issues which eventually exceeded $50 billion of par value. Yet even this wasn't enough.
And here is where the problem gets worse and frankly, sickens me to write about.

Freddie was supposed to raise $5.5 billion according to its earnings announcement back in June 2008. The problem is that it decided to wait for a better time in the market to raise this capital. However, in the meantime, its common stock price plummeted from $25 at the time of their announcement to a recent $5. While they only have 750 million shares outstanding, issuing 1.5 billion new shares really wasn't an option as this would dilute the current shareholders beyond recognition.

At the same time the market for mortgages, housing, CDO's, CLO's, etc worsened which simply added to their trouble. When Federal Reserve governors start calling Fannie and Freddie 'insolvent' in the press, it doesn't exactly instill confidence.

At this point, their preferred shares began to sink precipitously-as much as 60% below par value. My firm had originally purchased these issues at a discount to par, but sold them in this initial move down as we began to understand that safety of these issues was not necessarily going to be back-stopped by the implicit guarantee of the government.

Fast forward to today and now Treasury Secretary Paulsen is cooking up a bailout of Fannie and Freddie, which I imagine will eventually end up as full-fledged nationalization as I have been talking about for some time.

This first part was dicey, but this next part is just sad. When I decided to venture into GSE preferred shares last year, I thought that they would be nationalized and that these issues would be made 'money good.' Wrong.

After many discussions with informed traders and bankers, the plan that I envision (as revolting as it may sound) goes like this:

The Treasury would issue a 'super-senior' preferred stock offering that gives them effective control of Fannie and Freddie. At the same time, though, the equity shareholders who have ridden the stocks down 95% will get little if anything. I would also imagine (and the market seems to be pricing this in now) that the dividends on the $50 billion or so of outstanding preferred shares (mostly owned by institutional investors) will be suspended. Keep in mind that these issues are non-cumulative, non-mandatory preferred shares.

This means that if/when they stop paying dividends, they don't get to accrue future dividends, they just simply resume at some point in the future if this all works out. So what is the value of a preferred equity that doesn't pay a dividend...? Very little. Effectively what you own is an option on a future uncertain stream of dividend income that may start again in the future.

The result of all of this is that Congress will need to vote to increase the Treasury's debt ceiling to eventually accommodate all of the GSE's debt obligations back onto the federal balance sheet. But think of it this way-common and preferred shareholders, who took risk, will get nothing, and we will then be asked to hand over capital to the government so that they can get control and a senior position.

If this happens, we will all be paying twice, losing money in the common and preferred and then writing a blank check to Uncle Sam simultaneously. This doesn't seem at all democratic or fair to those that took risk and must pay for mistakes made by others.

What sickens me is that Hank Paulson & Co. are rather aware that Fannie and Freddie must be able to function normally to avoid global, financial systemic risk. And they will do anything to support them that they have to, including 'throwing taxpayers under the bus.'

While I am fairly confident my view will play out, I openly wonder if this model won't be used for other troubled institutions (like overleveraged financial concerns like Lehman, Merrill, Citi and AIG). They are important to the system as well. The Fed and Treasury know this, of course, and the while many important entities will probably be saved, there may be many others that are too small to care about and so poorly run that no one wants them -- you can throw National City (NCC), Zions (ZION), Regions Financial (RF), KeyCorp (KEY), into this category -- not to mention countless privately controlled community banks.

Part 2 can be found here. Part 3 can be found here.
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