The Dangers Still Lurking at Freddie and Fannie

What was implicit now has become explicit. What was feared, and desperately needed, has now become reality. The world's largest government bailout has begun.

Finally, after years of ignoring the fire-engine-red alarms clanging at the world's biggest mortgage-finance giants, the government has seized Freddie Mac (FRE) and Fannie Mae (FNM) and tossed their executive management team.

I warned you two weeks ago that the government would step in before the end of the month, as Freddie and Fannie were shockingly undercapitalized in the face of looming balance sheet-potholes submarined in footnotes, and amid mounting mortgage defaults and foreclosures (See my blog: The Fannie and Freddie Bail-out: Sooner Than You Think).

Seizing the two means losses potentially could surpass the tens of billions of dollars range, depending on how much more houses drop in value. And government banking sources say 25 to 30 regional banks could be in trouble if their Fannie and Freddie preferred shares get chopped down in size, which is likely the case. More on that in a minute.

Fannie and Freddie buy home mortgages from banks and then repackage these loans as mortgage-backed securities, which they either hold on their own books or sell to investors around the planet. The system recycles money back to the banks, which then use the funds to provide more home loans.

The problem is Fannie and Freddie have taken on too many bad mortgages, which threaten to submerge them under water. The two even bought subprime securitizations through 2007 when the housing bubble burst, picking up the slack for banks when Wall Street shut down its printing press factory that had cranked out a drunken daisy chain of mortgage-backed paper that stretched from here to Norway to the Arctic to Asia and beyond.

This is beyond impenetrably stupid. Buying these asset-backed securities well into the bursting of the housing bubble is equivalent to smoking in bed while the house is on fire.

To find out where the dangers still lurk, for the accounting problems and potential taxpayer losses, read through to the bottom.

Now the government has seized them, finally, because enough was enough, after years of reckless mismanagement, a history of accounting misdeeds and now record losses, $14 bn for the two over the last four quarters -- with more on the way, as the national default rate on mortgages has hit a huge 9%. To date, the credit crisis has created $515 bn in losses and writedowns, and Fannie and Freddie will bear a sizable portion.

Shares in Fannie and Freddie are down more than 80% over the past year. Citigroup has put a sell rating on both their stocks, cutting Fannie Mae's stock-price target to 32 cents from $9, and Freddie Mac's price target to 31 cents from $6. Their common shares now trade around the price of a gallon of gasoline.

I have repeatedly warned you that as mortgage delinquencies and defaults, notably on subprime loans and Alt-A loans, continue to rise, and increasingly even prime loans bellyflop, Fannie and Freddie will continue to book losses well into 2009 and possibly beyond (see my blogs: "More Losses Expected for Fannie and Freddie", "Why You Should be Worried About the Rescue of Fannie Mae and Freddie Mac," "Fannie and Freddie on the Brink," "A Rescue Plan for Freddie Mac and Fannie Mae").

Credit Suisse agreed in a recent report, and analysts say they may lose an additional $24 bn or more--I think it will be more.

It was always buried in the numbers at Freddie Mac and Fannie Mae for anyone to see. Correcting their accounting problems will spill red ink that will swamp their capital cushions for years to come, triggering sizable taxpayer losses.

The plan does not permanently liquefy these two mortgage-finance companies. Instead, it buys them time.

Wall Street, with the help of Fannie and Freddie, shot these risky loans into the ether via securitizations from here to the Arctic Circle, thus breaking the bond between the overseer, meaning the lender, and the borrower.

Why care about monitoring a borrower who can easily walk away from a mortgage as he or she has no skin in the game with a zero-down loan, when you've entirely offloaded that loan as a security? Many of these zombie securities backed by dead loans walking are now sluicing poison through the banking system.

Now the government must be seen to be making a profit for taxpayers in order to sell the Fannie-Freddie rescue plan to Congress and the public.

It will be a tough sell. The way these two publicly traded companies recklessly built and operated their Ponzi-type business model boggles the mind. Teetering atop their combined $54 bn net worth is a breathtaking pyramid of debt and assets, $5.4 tn of U.S. home loans, nearly half the size of the U.S. gross domestic product. They guarantee nearly 80% of all new U.S. mortgages. The two are intrinsic to the government's new $300 bn housing bailout bill.

That tiny capital cushion amounts to less than 1% of the mortgages they either own or back. JPMorgan Chase (JPM) or Bank of America (BAC) for example, have almost as much bank-level capital as these two "combined supporting one fifth of the commitments," says the research Web site The Institutional Risk Analyst, published by Lord, Whalen LLC.

"Thanks to the government's implicit guarantee of their debts, they were able to leverage their capital by as much as 50-to-1," says economist Edward Yardeni. "It doesn't take much in loan losses and asset write-downs to wipe out capital with that kind of leverage."

Indeed, just a 1% loss would wipe out their combined shareholder equity entirely.

The two are now being placed into conservatorship, making the U.S. government the world's biggest mortgage lender. "The lender of last resort is no longer only the Fed, but also the U.S. Treasury," says Yardeni. "The loser of last resort is now the U.S. taxpayer."

The two recently were desperately racing to do equity raises--Fannie raised $14.4 bn since last November, Freddie sold $6 bn in preferreds but failed to do a subsequent $5.5 bn offering--but it became ludicrous to do so, given that a new equity offering would be as much as their market values. And who would want to buy in, given that the shares could plummet anyway?

Fannie's market capitalization sits at $7.6 bn, down from $38.9 bn as of December 2007. Freddie's valuation fell to $3.3 bn from $22 bn over the same period.

Despite Freddie and Fannie's assurances that all was well, the government had to hire Morgan Stanley to pore through their books to see what time bombs really lurked in the shadows.

That in and of itself was a glaring vote of no confidence, triggering questions over whether their executives really knew what was going on at their own companies. Freddie was just surfacing from an accounting scandal that found it had massaged profits by about $5 bn; Fannie made accounting mistakes amounting to $6.3 bn.

Morgan Stanley's verdict was calamitous. Based on its estimates of mortgage losses over the next year and a half, the Wall Street firm figured that the two companies needed as much as $50 bn.

Freddie was in the most perilous condition, Morgan Stanley found, as it was seen to have overstated its capital cushion. Freddie in effect was doing what Freddie does--pushing losses into the future and delaying a capital shortfall until the end of the year.

For years Fannie sat on the government's books, helping to expand the real estate industry. In 1968, the LBJ administration, worried about the effect of the Vietnam War on the federal budget, moved Fannie Mae off the government's books, and Fannie became a publicly traded company.

When the savings-and-loan industry wanted its own mortgage financing creature to play with beginning in 1968, Congress obliged and in 1970 Freddie Mac was born. The two quasi-socialist mortgage finance giants then became to the U.S. economy what off-balance-sheet vehicles were to Enron, market watcher Dennis Gartman says.

Back when Freddie and Fannie were born as publicly traded companies in the late '60s, the two had about $15 bn in borrowings, supported by their $2.25 bn credit pipelines each into the Treasury. Today the two each have about $800 bn in debt they've borrowed to run their operations. That means if their Treasury pipeline had kept up, today those pipelines should each be about $120 bn each.

For years, Wall Street believed their obligations were "nearly as good as Treasurys themselves," notes Dennis Gartman of The Gartman Letter. Indeed, their securities traded as if the government backed them, and US government debt traded as if the government did not back them.

Both are in the process of rolling over $223 bn in debt right now, triggering acid reflux in an already tight credit market, as worries about their capital have caused their borrowing costs to soar to record levels over U.S. Treasuries.

As the companies' cost of borrowing grew prohibitively expensive, at the same time central banks in China, Japan and Russia are dialing down their purchases of the companies' debt.

Now the government will have to issue more Treasurys down the road to pay for the rescue plan, which will cause rates to go up and the dollar to plunge in value, as the government is already forecasting a $482 bn budget deficit next year.

First the plan, which wipes out dividend payments to current investors and preserves the principal and interest payments on the companies' debt, a move that will calm foreign central banks and other holders of their debt securities. Remember, the government's estimate of the cost to taxpayers for the S&L crisis rose from an initial $50 bn to more than $124.6 bn (not inflation adjusted). It eventually cost more than $500 bn.

The Treasury will buy, on behalf of taxpayers, $1 bn each in Fannie's and Freddie's senior preferred stock, a stake which will pay the Treasury a dividend equal to a 10% interest rate coupon ($100 mn from each annually to start).

The investment could grow to as much as $200 bn of senior preferred stock ($100 bn in each), coming in periodic installments.

The Treasury also gets an unspecified quarterly payment, or fee, to compensate it for any taxpayer money injected into the companies. In exchange for the investment in the preferreds, the Treasury will get stock warrants, or purchase rights, for 79.9% each of the companies' common shares at less than $1 a share.  The stakes will be senior to both existing preferred and common shares.

The Treasury's equity stake will now be ranked above both existing preferred and common shares, which could send another howitzer into the kitchen at the regional banks and thrifts already reeling from losses who hold about $36 bn in Fannie and Freddie preferred shares, which they've included along with Freddie's and Fannie's common in their own capital cushions.

If the preferreds lose value, which they have been, a double whammy ensues--the regionals must take a writedown and do offerings themselves, ironically, perhaps preferred offerings. JPMorgan Chase already reports it expects to take a $600 mn loss on its preferred shares in its third quarter, half of its holdings.

Marketwatch, a business web site, reports that the Office of Thrift Supervision, the government agency that oversees savings and loans, said 17 thrifts owned common or preferred shares of Fannie Mae and Freddie Mac that was more than 10% of their Tier 1 capital. Government regulators are moving quickly to help these banks "to develop capital-restoration plans" if needed, Marketwatch reports.

After the plan was announced, credit rating agency Standard & Poor's downgraded Fannie and Freddie's preferred stock to junk-bond status, but reaffirmed the U.S. government's triple-A rating. Moody's already slashed ratings on preferred stock of Fannie and Freddie, to Baa3 from A1 on Aug. 22.

"We structured this very carefully to protect the taxpayers," Treasury secretary Henry Paulson told WAMU radio. "And to the extent that taxpayers are going to put preferred stock into this entity, it will be structured so that the first losses will be borne by the existing shareholders.

The conservatorship does not wipe out the outstanding preferred stock, but the preferred shareholders will absorb losses immediately after the common shareholders, who are first in line to be hit with losses in the new structure.

Also, dividends on Fannie and Freddie's common and preferred stock will be erased in order to conserve about $2 bn annually, further hurting the regionals.

Next, the two also get a new, unlimited secured lending credit facility, an expansion of their existing $2.25 bn ($5.5 bn total) credit pipelines into the Treasury. The two get to post as collateral the same mortgage-backed securities they get to mint, with durations, however, that are less than a month and no shorter than one week.

The Treasury Department also plans to purchase new mortgage-backed securities issued by the two companies later this month, starting with a $5 bn purchase this month.

The move is similar to the move by the Federal Reserve last March to provide $29 bn of financing to prevent Bear Stearns's collapse, in which the Fed has taken on Bear Stearns's bad paper, hoping to sell it at a profit to taxpayers.

Now, the Treasury, or rather the taxpayer, will be on the other side of the Freddie and Fannie trade, buying the paper manufactured by financial firms and securitized by the two mortgage giants.

The two companies also get to expand their securitization book to $1.7 tn from $1.5 tn ($850 bn each by December 2009), but starting in January 2010, they will have to start paring back their portfolios of mortgage backed securities by 10% a year, until they hit $250 bn each.

The government has also finally, gratefully, ordered the two to stop their political lobbying, in which they paid $170 mn in political donations over the last decade to get Congress to ease up on regulatory oversight.

But the exposures are still there. The Office of Housing Enterprise and Oversight says in a new report that the two combined own about $217 bn in securities minted by Wall Street firms that are backed by the shakiest home mortgages dating to 2004 and 2005, the height of the housing bubble.

Specifically, they own $217 bn in subprime and Alt-A securitizations, Alt-A being the still risky loans that sit between prime and subprime as they include loans made with less than full documentation of borrowers' income or assets.

As Wall Street stepped back, check out how Fannie and Freddie stepped in big time.

OFHEO says in its recent report that while the volume of single-family mortgages securitized in 2007 fell by 8% to $1.9 tn, as the number of single family mortgages originated declined, "Fannie Mae's and Freddie Mac's combined share of MBS [mortgage-backed securities] issuance rose substantially to 61.6% from 46.7% in 2006."

Indeed, OFHEO says Fannie and Freddie "increased their MBS issuance by nearly one-third in 2007 as competition" from Wall Street "virtually ceased in the second half of the year," though OFHEO says the two started to curtail their purchases of securities backed by shoddy loans. Too little too late.

Today, nationwide, the percentage of Alt-A mortgages in arrears quadrupled to 12% recently from a year earlier. Delinquencies among prime loans, which account for most of the $12 tn market, doubled to 2.7% in that time.

The Alt-A mortgages are a huge problem for both Fannie and Freddie. Their Alt-A loan exposures created 50% of credit losses in the second quarter, even though such loans accounted for only about 10% of the companies' business.

Freddie was found to have not written down a huge slug of these loans to fair value, a process called marking to market. As the markets for these securities have frozen, Wall Street firms and banks around the globe have been forced to take sizable writedowns on these portfolios.

It's a hot debate, one I've warned you about before. Companies believe these assets will toss off some cash flow down the road, and Freddie's argument was that they intend to hold these assets to maturity when they may be worth more. Most banks write off losses when loans are three months due-in some cases, Freddie and Fannie were waiting as long as two years, The New York Times reports.

Also, both were "too slow to provision for loan losses," economist Yardeni says, noting that  Joseph Abbott, his chief quantitative strategist, compared the loan loss provisions of 24 selected financial companies in the S&P 500. Fannie and Freddie collectively set aside a total of just $5.1 bn in reserves to handle losses over the past four quarters. "By comparison, Citigroup, Bank of America, and JPMorgan chase each piled up $25.1 bn , $17.2 bn, and $12.2 bn, respectively over this period," Yardeni says.

Both also have inflated their assets with deferred-tax credits, which can't be sold and only have some value if a company has profits.

The New York Times reports that they inflated their financial positions by using deferred tax assets, or losses that take the form of credits under tax law that they've accumulated over the years to offset future profits. Fannie booked in its assets $36 bn in such credits; Freddie, $28 bn. But the fact that they have been booking losses means they could not use the credits, and the paper assets kept piling up.

What else?

*Freddie has $156.8 bn in level three assets, those illiquid securities it can't get a pricetag on because no one wants them now. Remember, under U.S. accounting rules, it gets to assign its own values to these assets: They could be worth more, they could be worth less.

*Fannie has $56.1 bn in level three assets, or about a seventh of its fair-valued assets.

*Fannie and Freddie have combined debts of $1.59 tn, borrowings they made merely to operate their businesses. Again, that's against just $54 bn in total net worth. Their guaranteed liabilities were 29 times their net worth at the end of the first quarter.