The Final Fate of Fannie and Freddie

The market's pummeling of Freddie Mac (FRE) and Fannie Mae (FNM) eased up a bit on Aug. 21, after four days of selling. But with the stocks both down more than 85% year-to-date, investors appear to believe it's a question of when, not if, the Treasury Dept. will be forced to use its newly acquired powers to bail out the mortgage giants.

Of course, the authority Congress granted to Treasury Secretary Henry Paulson to invest in Fannie and Freddie's shares—or make loans to the troubled companies—was supposed to strengthen them. It's had the opposite effect. The stocks are now both trading under 5, a sign that investors believe the companies' common equity will be wiped out in any bailout package.

But the pain goes deeper. Preferred shares of the government-sponsored enterprises (GSEs) have lost roughly 80% of their value, as Wall Street ponders their fate. Even their subordinated debt, which historically traded at a similar yield to the GSE's senior debt, now trades at historically wide spreads of three to four percentage points above the senior debt. Only senior creditors seem completely assured of getting their money back. But neither Treasury officials nor Fannie and Freddie executives are giving their plans away just yet. "It's kind of [like] radio silence," says one credit trader familiar with the situation.

Holding the Status Quo

Of course, some argue that a bailout can wait. As of early August, both Fannie's and Freddie's capital holdings were above their mandatory levels, with Freddie possessing a capital requirement surplus of $2.7 billion and Fannie holding $9.4 billion in additional cash. Credit research outfit CreditSights estimates that Fannie and Freddie could lose $17.3 billion and $8 billion, respectively, before breaching government-mandated capital levels. Meanwhile, both continue to be able to service their debt at a reasonable, if historically high, interest rate about 30 basis points below the London interbank offered rate.

Paulson is probably just hoping the status quo holds for a while longer. When he argued in favor of Treasury's increased power over Fannie and Freddie in July, Paulson claimed that just having the ability to act would prevent him from needing to. The Bush Administration is hoping to steer clear of another high-profile bailout after the Bear Stearns mess, and if Fannie's and Freddie's capital positions hold up reasonably well, Treasury could wait for the GSEs to burn through their cash before making any moves. The "key players would likely prefer to delay action until after the November elections if possible," Richard Hofmann, an analyst at CreditSights, wrote in a recent research report.

Treasury, however, may not have the luxury of time. While Fannie was able to raise $7.4 billion during the second quarter, Freddie held off on seeking the $5.5 billion it announced it would raise. With its stock at 3.16 and speculation high that a bailout is inevitable, it may be difficult to coax additional capital into Freddie's coffers, either with common stock or preferred shares. Without the cash, Freddie could breach its mandatory surplus threshold in the third quarter of this year.

The Olympics of Finance

And so, the GSE watch has become the financial world's version of the Olympics—no one can take their eyes off it. Part of this is practical, as banks hold enormous amounts of Fannie and Freddie preferred shares and subordinated debt on their balance sheets. If the preferred equity is wiped out, banks will have to take more capital writedowns, adding to their already enormous troubles, says Dory Wiley, CEO of Dallas-based Commerce Street Capital.

Fannie and Freddie make up about half of the U.S. mortgage market, and with them on the ropes, there's little chance for a housing recovery. Without a housing recovery, the credit markets will continue to be jammed up. And things promise to get worse before they get better. Fannie and Freddie have about $250 billion in debt to refinance in September, and everyone will be watching to see if they're successful. As long as their futures are uncertain, much of the credit market will remain in the doldrums. "They're the pivot point of the whole credit market," says Samson Capital Advisors' Benjamin Thompson.

Of course, there's one simple solution to the GSE problem: nationalize them, says analyst Chris Whalen of Institutional Risk Analytics. He says the Treasury should go ahead and wipe out the common equity, which the market has pretty much done on its own anyway, and promise to make holders of preferred stocks and subordinated debt whole. And financing? If the two mortgage financiers are taken over by the government, notes Whalen, "you don't have to worry about financing."

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