Fannie Mae and Freddie Mac

Alchemist · #1 15th July 2008, 07:44 PM

I already have a thread on writedowns by US financial institutions:

Season of Writedowns in US - What a Mess.

However the problems of Fannie Mae and Freddie Mac are much bigger.

They deserve a special thread.

Maybe after reading this thread, some of you may feel they actually deserve a dedicated sub-forum...

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Firstly, you must be wondering what are these two entities and why should anyone ever bother about them?

Fannie Mae

is actually Federal National Mortgage Association.

Freddie Mac

is actually Federal Home Loan Mortgage Corporation.

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Obviously, you must have guessed by now that these two are in the business of mortgages.

However, Fannie Mae and Freddie Mac are very different from other lenders in the US mortgage market.

Fannie Mae and Freddie Mac don't lend directly to retail borrowers.

Instead, they provide liquidity to other mortgage lenders.

Fannie Mae and Freddie Mac buy mortgages from lenders and free their capital.

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e.g.

Mr. ABC wants a mortgage loan.

He goes to PQR Bank.

PQR bank gives Mr. ABC the loan.

Now this loan is an asset for PQR bank and liability of Mr. ABC.

PQR bank sells this asset (loan) to Fannie Mae or Freddie Mac.

PQR bank gets 8% interest from Mr ABC and pays 7.5% to Fannie Mae or Freddie Mac.

Fannie Mae and Freddie Mac gets 7.5% interest from PQR bank and pays 7% interest to its lenders.

(The interest rate figures are just an example).

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Fannie Mae and Freddie Mac don't just make money from interest rate differences.

They do one more thing.

They bundle many mortgages together and create mortgage-backed securities.

I wrote that in red. Many of you must be familiar with those words:

"mortgage-backed securities".

That is where the credit crisis started from.

These mortgage-backed securities are then sold to investors as complex debt instruments.

The important point that Fannie Mae and Freddie Mac guarantee that these debt will be paid back. This guarantee comes at fee and this is the second source of income for these two.

Even if the borrowers default, Fannie Mae and Freddie Mac have to pay back this debt to the investors.

and this is where all troubles start for Fannie Mae and Freddie Mac.

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Fannie Mae and Freddie Mac are not small institutions.

They are small by market value as their share prices have crashed.

However, their businesses are huge.

In fact their businesses are so huge that they make SBI and ICICI seem like tiny banks.

Together, Fannie Mae and Freddie Mac hold or guarantee nearly half of the mortgages in the US.

That comes out to be around $5 trillion.

That is 5 times India's annual GDP.

Around $1.5 trillion of mortgages are with these two and $3.5 trillion of mortgages are with investors in the form of mortgage-backed securities.

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The problems with Fannie Mae and Freddie Mac are simple, but the solutions aren't.

Borrowers are defaulting.

(Fannie Mae and Freddie Mac have no exposure to sub-prime mortgages. They don't buy sub-prime mortgages. However the mortgage problem is no longer limited to only sub-prime mortgages).

If borrowers default, cash flow stops for Fannie Mae and Freddie Mac.

However Fannie Mae and Freddie Mac has to pay back the debt that it has.

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If these two were banks, the problems wouldn't be so serious.

It is mandatory for banks to maintain certain capital of their own. This is what capital adequacy is all about.

Fannie Mae and Freddie Mac don't have to follow banking regulations.

at a 78:1 debt-to-equity ratio it is levered many times what is allowed international banks.

Thus, their capital is no longer enough to hedge its investors (of mortgage-backed securities) and creditors from defaults by home owners.

Quote:

at a 78:1 debt-to-equity ratio Fannie Mae is levered many times what is allowed international banks.

Source.

Taking more debt to payback earlier debt won't solve the problems. The US federal reserve has assured that it will give credit to both.

However, this is just be a debt and has to be paid back.

A solution to this problem is that Fannie Mae and Freddie Mac raise capital by equity dilution.

but even this seems impossible now.

The share price of both these companies is so low now that no amount of equity dilution will bring enough capital to stabilize them.

Current price of Fannie Mae's stock is $7.1 and market value is $6.9 billion.
Current price of Freddie Mac's stock is $4.9 and market value is $3.2 billion.

Companies with market value of $10 billion giving a guarantee for $3.5 trillion of mortgages.......perfect recipe for an economic disaster.

Thus both the option of debt-raising and equity-dilution aren't going to solve the problems for these two.

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Will Fannie Mae and Freddie Mac go bankrupt?

No.

Why?

coz US government will come to its rescue.

In fact, the US government has no choice.

Fannie Mae and Freddie Mac are too big to be allowed to fail.

to be continued.....

Alchemist · #2 21st August 2008, 06:47 PM

Both Fannie Mae and Freddie Mac have reached a stage, where the only option left, is a bailout from the government.

The stocks hit new 2008 lows yesterday.

Investors fear that the government will buy preference shares from these two companies.

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Preference shares provide a specific dividend, that is paid before any dividends are paid to common stock holders, and these take precedence over common shares in the event of a liquidation.

If Fannie Mae and Freddie Mac issue preference shares to the Federal Reserve, the value of common stock would become zero.

(Possibly both companies already have a negative net worth).

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If I were in the US, I would have shorted these stocks a long back..

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Chart 1 (Fannie Mae).
Chart 2 (Freddie Mac).

Alchemist · #3 6th September 2008, 04:23 PM

After US markets closed yesterday, reports have emerged that the US Federal Reserve is close to taking over the two troubled institutions.

Stocks of both Fannie Mae and Freddie Mac were down over 20% in after-hours trading.

The announcement is expected today (Saturday morning).

If the news reports are true, then stocks of other financials may also be negatively impacted in Monday's trade.

(In my opinion, this news won't really have a direct impact on Indian markets).

Quote:

The U.S. government plans to put government sponsored mortgage finance companies Fannie Mae and Freddie Mac under federal control, the New York Times and Washington Post newspapers reported late Friday, in what could be the largest financial bailout in the nation's history.

The value of the company's common stock would be diluted but not wiped out, while the holdings of other securities, including company debt and preferred shares, would be protected by the government, the Washington Post said.

Source.

Alchemist · #4 7th September 2008, 08:03 PM

This article explains the problems at Fannie Mae and Freddie Mac in a simple manner.

Quote:

.....review found the beleaguered mortgage-finance companies used accounting methods that inflated their capital

Quote:

The Treasury plans to put Fannie and Freddie into a so- called conservatorship and pump capital into the companies.

Quote:

Concern over the companies' capital pushed their borrowing costs to record levels over U.S. Treasuries, sent their common and preferred stocks tumbling and boosted mortgage rates.

Quote:

Fannie had $47 billion of capital as of June 30, according to company filings. The company is required by its regulator to hold $37.5 billion. Freddie's capital stood at $37.1 billion, compared with a requirement of $34.5 billion, filings show.

Quote:

The legislation that President George Bush signed July 30 also gave the Treasury the power through the end of next year to extend unlimited credit to or make equity purchases in the firms.

Quote:

As of mid-August the companies had $223 billion of debt to refinance by the end of the quarter.

While they have continued to issue securities, Fannie and Freddie have paid record yields over U.S. Treasuries to attract investors reluctant to take on the debt even with its implicit backing from the government.

San Yad · #5 8th September 2008, 07:10 AM

Asian markets are up by approx 3% this morning due to this Fannie Mae and Freddie Mac news..

What is the impact for long term on USA and Indian economy after this news? You think this can help US to protect somehow from recession phase?

Alchemist · #6 8th September 2008, 09:28 AM

Quote:

Originally Posted by sanyad74

Asian markets are up by approx 3% this morning due to this Fannie Mae and Freddie Mac news..

What is the impact for long term on USA and Indian economy after this news? You think this can help US to protect somehow from recession phase?

No major impact for Asian markets. (Asia has limited direct exposure to these institutions).

It may seem like a positive for US markets, but the truth is that these two institutions were bailed out because they were no more than 2-3 quarters from insolvency.

In fact, it actually shows how fast the rot in the sub-prime market has spread to prime market in US housing industry.

See the first post:

Quote:

(Fannie Mae and Freddie Mac have no exposure to sub-prime mortgages. They don't buy sub-prime mortgages. However the mortgage problem is no longer limited to only sub-prime mortgages).

It is only a precursor of what lies ahead for the US economy...

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The move is:

Good for institutions that hold debt of Fannie Mae and Freddie Mac.

Bad for institutions that hold equity of Fannie Mae and Freddie Mac.

shasha · #7 9th September 2008, 03:02 AM

Alchemist,

Stocks Markets around the World moved up following rescue efforts by US Govt. of these Giant Mortgage Holders from going Bust. Going Forward, do you think common Stock holders have any stake in these companies. Is it better to sell their stocks even though the money they get is pittance? or to just hold on till things get clear.

Thanks for the Advice.

Alchemist · #8 9th September 2008, 08:55 AM

Quote:

Originally Posted by shasha

Alchemist,

Stocks Markets around the World moved up following rescue efforts by US Govt. of these Giant Mortgage Holders from going Bust. Going Forward, do you think common Stock holders have any stake in these companies. Is it better to sell their stocks even though the money they get is pittance? or to just hold on till things get clear.

Thanks for the Advice.

Both stocks have become penny stocks.

Fannie Mae closed at 73 cents and Freddie Mac closed at 88 cents yesterday.

I don't think these stocks will ever recover. The companies are as good as bankrupt now.

Selling them would be a good idea.

Chart 1 (Fannie Mae)
Chart 2 (Freddie Mac)

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BTW, I found this article on which financial institutions were positively impacted and which were negatively impacted by the Fannie and Freddie bailout.

shasha · #9 9th September 2008, 07:24 PM

Thanks Alchemist on your advice!