Monday, September 15, 2008

Why Fannie and Freddie Cannot Be Safely Bought

I've seen a certain amount of excitement caused by the sudden price decline at the Federal Home Loan Mortgage Association (Ticker:FRE), known as Freddie Mac, and its sister organization Fannie Mae (Ticker:FNM) (formally known as the Federal National Mortgage Association). The idea is that when folks see a chart like the one below, they suspect there may be a bargain to be had.

I explain why there is no bargain now in busted guarantee companies.
I'll list a number of the canards I've seen people try to fly as they purport to explain why the stocks are a now a screaming buy and a good place for contrarians. As I explained toward the bottom of a post that bashes stock analysts, merely voting against the majority isn't sufficient to win accolades as a sharp-witted contrarian: you also need to know something that will prove you right. While I love contrarians and bucking trends, the danger of following a fanatic cadre off a cliff merely because they refuse to believe their topographical maps is so great in FRE and FNM that I feel impelled to spell out the bear case. To begin arguing any case for valuation, however, a few basic principles should be established.

Data Govern Fair Valuation
The fair value of a stock can be uncertain because the data are uncertain (like the scale of future loan defaults), or because the valuation principles are in dispute (like whether a particular company, due to its accounting practices or tax structure or some other factor, should be better valued on the basis of its cash flow or on the basis of its earnings, and how to value non-income-producing assets on the books, and whether future earnings are securely-enough known that present prices should be based on their estimate). The range of dispute reasonable people can maintain in the face of this kind of disagreement isn't necessarily trivial, either. To accept the thesis that FRE and FNM are scary to own, it's not necessary to drink any special accounting Kool-Aid.

Let me assure you that very little math or accounting sophistication is needed to see why FRE and FNM are scary to own. The documents set forth by the federal government for broad public consumption give a clear and concise explanation why you don't want to touch the equity of either company just now, and why future returns are likely to be very modest if the companies are eventually righted and allowed to sail again under shareholder-selected rather than federally-appointed management (more on this point later).

I will assume throughout that people expect to value a financial company either on the basis of earnings (people hunting for an attractive P/E or PEG), or on the basis of net worth (people looking to buy a deal below its liquidation value). I intend demonstrating that adherents to either approach should feel the hair raise on their arms and neck as they contemplate risking capital on the common shares of FRE or FNM.

What Is A Loan Guarantor's Business, Anyway?
Fannie and Freddie are financial companies. They make money handling money. The amount of money they can make is directly related to the scale of the finances they are handling. In the case of Fannie and Freddie, the missions of the organization don't require them to hold a great deal of mortgage debt, but they do require them to exercise prudence in investment decisions:
The Corporation is authorized to purchase, and make commitments to purchase, residential mortgages. The Corporation may hold and deal with, and sell or otherwise dispose of, pursuant to commitments or otherwise, any such mortgage or interest therein. The operations of the Corporation under this section shall be confined so far as practicable to residential mortgages which are deemed by the Corporation to be of such quality, type, and class as to meet generally the purchase standards imposed by private institutional mortgage investors.
The idea behind these companies is to help capital access the mortgage market, and to enable mortgage vendors to access the capital markets. This is spelled out by Congress in the first section of the Act creating the guarantee corporations. (I'll use Freddie for my examples, but I haven't seen any indication that Fannie has done differently. Both required simultaneous bailout.) In practice, the mortgage resale business as conducted by these guarantors looks like this:
One of the means by which we fund purchases of mortgages loans is through the use of securitization-based financing. We issue a mortgage-related security that represents an undivided interest in the mortgage loans we purchase. We then provide a guarantee of the payment of principal and interest on all securities. Our customers may choose to hold these securities in their portfolios or sell them to other investors.
Freddie Mac, "Our Busines"
In other words, it's as if a check-cashing company, instead of presenting checks to the maker's bank for payment, instead sold them in turn to another check-cashing company -- but personally guaranteed the check, in case the maker's bank dishonored it. On the page Freddie links to in the quote above, Freddie spells out exactly what kind of risks it assumed as the subprime market went nuts:

We purchase mortgages from across the country that share similar characteristics – payment terms, interest rate, loan term – and yet may have other characteristics that vary. For example, some mortgages may carry greater credit risk than others, based on the type of property or the credit history of the borrowers.

Freddie Mac purchases large numbers of mortgages that we "pool", or bundle together, into large groups. We guarantee timely payment of principal and interest to the investors who invest in these pools.

Freddie Mac, "Understanding Securities" (emphasis added)

Freddie boosted the yield of mortgage-backed securities by bunlding high-risk loans into the mortgage pools, then guaranteed timely payment of interest in principal on the whole. Think on this a moment. Freddie must make payments to the holders of all the mortgages Freddie ever flipped, evan as the public shakes in fear that the economy will worsen and more loans will default. Freddie must make these payments from fees taken from the monthly payments it receives. As the monthly payments are imperiled, so will the fee stream that is supposed to fund the underpayments.

Nice, eh?

Okay, Freddie also charges fees to customer banks, but if these fees were a material source of the underpayment funding, you would see a stockpile of old lender fees against which to charge underpayments. There is no such fund at Freddie -- at least, not a fund that creates a net positive asset value, which people familiar with Freddie would have detected -- so Freddie's only chance is to fund its payment obligations from fees taken from current receipts.

But it gets worse.

There are some loans Freddie thought would be nice to keep on its own books to boost profits, and didn't syndicate. On Freddie's "Understanding Securities" page, Freddie explains in the section "How Debt Securities Work" (at the bottom of the page) that in order to attract to the mortgage market the funds of investors averse to prepayment risk, Freddie issues debt under its own credit and plows that into mortgages that it carries on its own books. Hmm. Anyone care to guess what kind of mortgages Freddie chose to carry on its own books when it was announcing to investors its aim to produce shareholder returns in the teens?

Now, after setting up the joke, we start getting to the punchline.

There is no equity in the shares.
I don't intend here to merely repeat what Warren Buffett said about the shares. I mean to be much blunter and prove what I've said with easy-to-follow quotes to widely-available sources of unimpeachable authority. With the absoluteness of black-lettered law, I will show there is no equity at all in the common shares of either FRE or FNM.  Those who buy the common shares of wither company right now are buying nothing more than a tall column of blue sky -- or less, as blue sky might have value -- on nothing more than the hope a rare bird will fly into the column and stop there, waiting to be turned into cash.  There is no business case, and only a speculative case, for buying the shares.

Nevertheless, Bufett said it first -- and voted with his pocketbook before there was even a general alarm, and I give full credit. (In my defense, I was never interested in the stocks and didn't follow them.) Warren Buffett, who was at one time Freddie's biggest investor and who is on record as preferring to hold investments forever, testified about liquidating his investment in Freddie Mac over a period beginning in the late 1990s. Buffett stated, under oath, that Fannie and Freddie "don't have any net worth" and that "the game is over" for Fanie and Freddie as independent companies.  He dumped the shares because he thought the Freddie badly run, and because he spotted confusing things -- like investments outside the corporate mission -- that led him to conclude (on the basis that there is never just one cockroach) that things were really wrong inside Freddie.  Buffett got it early.  


I admit upfront that I am going to cheat.  This is because I don't enjoy being found wrong. I am going to quote regulatory agency documents that prove the shares have no equity.

First, FRE and FNM are both companies whose regulators have imposed conservatorship. Doubtless management would have liked some other alternative, but as the link indicates, Secretary Paulson simply was unwilling to consider risking public money without getting conservatorship. Conservatorship seems to be misunderstood by some folks, so the government published a little Q&A sheet that spells it out:
Q: What happens upon appointment of a Conservator?
A: Once an “Order Appointing a Conservator” is signed by the Director of FHFA, the Conservator immediately succeeds to the (1) rights, titles, powers, and privileges of the Company, and any stockholder, officer, or director of the Company with respect to the Company and its assets, and (2) title to all books, records and assets of the Company held by any other custodian or third-party. The Conservator is then charged with the duty to operate the Company.
Federal Housing Finance Agency, "Questions and Answers on Conservatorship", p.2
This means that government conservator assumes all "rights ... with respect to the Company and its assets" -- divesting "any stockholder, officer, or director of the Company" of any rights previously held. The Conservator runs the Company as he sees fit, owning all its assets.  This is the kind of language one sees in state insurance insolvency statutes, vesting all the assets of a troubled insurer in the Insurance Commissioner.  This is not a typo.  The government regulator is now the legal owner of all the assets of FRE and FNM, and shareholders have exactly nothing.

As it happens, the Conservator hasn't decided to boot old management, but to continue with the old guard in place.  Given that the old guard is responsible for the insolvency that gave rise to the bailout and conservatorship, I would not be celebrating as a shareholder just yet.  The federal government takes the magnanimous position, at least publicly, that the financial troubles flowed from the conflicting missions of ensuring shareholder returns and encouraging ready access of mortgage lenders to the capital markets.  This same conflict will be handled a bit differently by the management under conservatorship:  the conservator has very slight interest in causing value to flow to common shareholders.

Before getting to the exit strategy -- that is, the road bulls must see the company traversing in order to make a purchase of common shares pay off as a long-term investment -- it's worth looking at what limitations and costs are associated with the bailout.

What Does Conservatorship Cost FRE and FNM?
Each company has lost all its assets.  Re-read the section above, the part about the meaning of conservatorship.  Got it?  Assets are zero.

But, as they say in the advertising world:  That's not all!

The sums advanced by the federal government -- and they are sums that don't have a fixed-in-advance size, just sums that Congress has capped at $100 billion per company -- "buy" the federal government a new class of stock, drafted by the federal government.  Every quarter, this new senior preferred stock (senior to any common or other preferred class) must be paid a cash dividend at an annual rate of 10% of the invested amount, or the amount will be payable at 12% and will yield more senior preferred shares.

Moreover, an undisclosed quarterly management fee ("commitment fee") will be payable to the United States Treasury, to be worked out between the federal conservator, the Chairman of the Federal Reserve, and the Secretary of the Treasury.  (Look at the Treasury Department Senior Preferred Stock Purchase Agreement Fact Sheet, third-to-last bullet point.)  You will notice that shareholders haven't got a vote on this, or even anyone shareholders elect.  Federal salarymen are going to establish the fee the government will charge from assets vested in the Conservator when he succeeded to title to the guarantors' assets.  Then, they will pay themselves the fee from the company's existing -- ahh, sorry -- from the conservator's new assets.

Longs should hope the federal government is both extremely efficient, and not greedy.  I'm thinking there are some readers who will stop at this point, laughing.  But, read on:  it gets better.

High Cost Debt
If these companies could borrow money cheaply and lend it at a higher rate, then the fact they've got some obligations payable at 10% might not be a big deal:  the newly-acquired mortgages might be good, paying, non-subprime loans, and any profit made on a loan spread from a paying loan is good earnings and great cash flow.  With the backing of the federal government, Fannie and Freddie might get good debt rates, too.  Alas, Fannie and Freddie are barred from raising money by issuing equity or substantially increasing debt without federal consent.  (Look at the second-to-last bullet point of the stock purchase agreement fact sheet.)  Fannie and Freddie are sentenced, in effect, to borrowing at 10-12% or not at all.  With mortgage rates for quality borrowers below this level, there's no spread to be made on prudent loans.

Since the Treasury Senior Preferred Stock Purchase Agreement puts the kibosh on any other shareholders' dividends -- that's billions conserved, right there -- patient longs haven't got much to keep them company as they wait for the company to get out from conservatorship, so it can maybe one day actually own assets again.  (Remember:  title to the rights in all the Company assets passed to the conservator.  Until conservatorship ends, shareholders have nada.)

How will Fannie and Freddie grow producing assets to the point it's possible to cover obligations, and begin amassing profits for owners?

The Incredible Shrinking Company
Growing new good cash flow from new, higher-quality retained investment holdings isn't the way FRE and FNM are going to be getting out of this:  they are required to shrink their businesses.  FRE and FNM must reduce their retained mortages and mortgage-backed securities steadily, first to $850 billion by the end of next year, then by 10% per year thereafter until the retained risk is $250 billion or less.  (Look at the Treasury Department Senior Preferred Stock Purchase Agreement Fact Sheet, linked above, at the very last bullet point.)

Shrinking the retained mortgages doesn't mean the companies' risk really declines, though:  the companies continue to guarantee the timely payment of principal and interest on mortgages and mortgage packages they flip to buyers.  Remember Freddie Mac's "Understanding Securities" page.  And consider this one:  would anyone buy a mortgage or mortgabe-backed instrument from Freddie or Fannie with a disclaimer that the loan guarantor refused to stand behind the mortgages?  Freddie and Fannie will stay on the hook for enormous volumes of past mortages.  As time passes, there is certainly a possibility that property value recoveries will make loan payment more attractive -- but who is ready to bet, now, that this will happen before fixed-rate teaser periods on ARMs expire, or the mortgagee loses his job, or the property is damaged beyond its insured value by a storm?  

People who want to make a bet on real estate recovery can do that directly, and people who want to bet on the recovery of mortgage-backed home loan values can use a vehicle with current net value and a strong current dividend backed by real earnings.  Why would someone interested in a real property play, or a mortage play, buy shares in a company whose rights and interests in mortgages had just been vested exclusively in a federal regulator?

But these questions get ahead of our story.

Regardless what loans Fannie and Freddie carry on their books, the ongoing obligation -- that is, ongoing risk -- for the timely payment of both principal and interest will still be borne by Fannie and Freddie.  Consider for a moment that Fannie and Freddie together guarantee an aggregate mortgage risk the size of the entire federal debt.  It could take a lot of funds to cover bad debts in a pool that size, and it could take considerable time to attain enough certainty regarding the quality of the whole pool that creditors assessing the companies' solvency without regard for federal guarantees would find the companies a reasonable credit risk.

To regain a plausible cash-flow position, neither FRE nor FNM will be able to make money acquiring solid mortgages with cheaply-borrowed funds, or by issuing more equity (other than to the federal government, at a 10% or 12% rate depending whether the dividend is paid in cash or in more senior preferred shares).  FRE and FNM will be required to become solvent while shrinking their book of retained mortgage holdings.  

This could be a long road.

How Can Conservatorship End?
According to the federal government's overview page on its bailout stock purchase agreement, Freddie and Fannie aren't entitled to seek an end to conservatorship, except through receivership.  (Look at the Treasury Department Senior Preferred Stock Purchase Agreement Fact Sheet, second-to-last bullet point, fourth sub-point.)  Receivership is the same fun as conservatorship, except that the aim of receivership isn't to run the companies but to cut creditor losses by liquidating them.  Receivership isn't in the interests of equity holders, who want to see the companies emerge from conservatorship solvent.

If nobody at the company can terminate conservatorship, who can?  The Federal Housing Finance Agency has issued a Q&A sheet that spells this out for the home viewer:
Q: When will the conservatorship period end?
A: Upon the Director’s determination that the Conservator’s plan to restore the Company to a safe and solvent condition has been completed successfully, the Director will issue an order terminating the conservatorship. At present, there is no exact time frame that can be given as to when this conservatorship may end.
Federal Housong Finance Agency, "Questions and Answers on Conservatorship", p.2
Shareholders will get their company back (well, all the company's rights and assets, if any) when the Director of the Federal Housing Finance Agency says so.  (This assumes that receivership isn't warranted.)  Shareholders have no say in the timing of termination of conservatorship. Shareholders must rely on the succes of federal appointees for the return on any investment made in common or preferred shares of FRE or FNM.

Dilution at 5:1
Assuming shareholders are eventually granted the return of the rights and authority to which the Conservator succeeded on initiation of the conservatorship, they will have some additional company:  the Treasury holds warrants amounting to 79.9% of the shares of both FRE and FNM, exercisable at "nominal cost".  (See the third bullet point on the list of terms in the Fact Sheet.)  Shareholders can look forward to a dilution just trivially different from 5:1 when they regain ... well, not control, the new 79.9% owner will have that, but when they regain something to back their shares.

At this point I'd like to speculate -- speculate, mind you -- on why the purchase agreement doesn't call for the Treasury to buy a newly-issued 80% of the common shares immediately.  I believe that a move to support the companies by buying equity at a time the companies were unable to save themselves issuing new equity would be so transparent a surrender of federal dollars to bail an insolvent private interest that it is politically impossible.  The preferred-plus-warrant structure ensures the Treasury the ability to claim it's getting a return on its investment, and allows Treasury material participation in the upside, if any, of a successful turnaround.  The size of the shareholder benefit is immaterial to the Treasury, which (a) is being paid 10% or 12% on its Senior Preferred, which is its only capital at risk, and (b) is more concerned about making sure there's not a panic among FRE or FNM debt holders than it is concerned about equity speculators who elected a management to conduct unsound business in the hope of returning mid-teens returns.  This way, Treasury assures all debtholders that they are safe -- the federal government as a preferred shareholder is paid after debtholders -- while not being a laughingstock for paying good money for obviously-worthless shares.  If in doubt, re-read the Warren Buffett quotes above, from before the shareholders were deprived of their rights in the company under the conservatorship order.

But eventually, if conservatorship is successful, FRE and FNM may see control return to shareholders.  At that time, existing shareholders should expect to see themselves own an aggregate of 20.1% of the companies they owned prior to conservatorship.  The dream of 2001-era returns should be discarded, as the companies are required to shrink their retained mortgage holdings under the preferred stock agreement and will be in a position to make a lot less money for the much larger number of shares.  Additionally, FNM and FRE will be amassing 10-12% obligations to the federal government every time they need a cash injection to keep afloat as their mortgage holdings and loan guarantees produce liabilities that would break a company without the federal government bailing it out.

Welcome to Fantasy Island!
The federal bailout doesn't require the Treasury to make common shares valuable, just to keep the company from being worthless in the face of debt obligations.  When FRE and FNM are set again in the hands of shareholders, one shouldn't expect to be drowning in profits, as the objective of conservatorship isn't shareholder value but debt-holder security and the availability of capital to morgage lenders.  The idea that the warrants constitute a 5:1 stock split and that the share price should trade in the teens based on profits created when the companies weren't saddled with 10-12% obligations to the Treasury and had the benefit of large, paying retained mortgage holdings -- an idea floated here -- seems to be based on a fantasy that neglects the companies' required shrinkage and the impact of increased debt costs, instead harkening back to an era in which accounting standards didn't require mark-to-market and the company could more easily make itself appear profitable.

Assuming everything goes well in conservatorship, the following are to be predicted:
  • Shareholder dilution of about 5:1
  • Reduction in overall company profits commensurate with decreased retained holdings and increased debt costs in conservatorship
  • Control passing from a federal office exercising the powers of the conservator, to a federal office voting a 79.9% control block of the company's common stock
  • Immediate need to reduce overhead caused by balooned senior preferred dividends (you can't think more cash won't be necessary as the full extent of loan guarantee obligations materialize, and with a mortgage pool the size of the entire federal debt, it won't take much of a default percentage to run the cash injection to the sky) by buying back the senior preferred, which might be expensive if the deal must be approved by the preferred owner itself (which is also the post-warrant majority common stockholder);  note that the value of the preferred will have increased with the solvency of the company by the time the company can afford to buy off the preferred interest
Given the zero assets, the prospect for zero profit, and the need to take on 10-12% debt from the government to solve cash flow or other problems along the way, it's entirely reasonable to doubt that the common shares will be worth $1 apiece, or even $0.10 apiece, when the day finally comes that conservatorship has ended.  Today, however, it's pretty sure that there's no business case for a postive share value, as there's no busines case for FNM or FRE;  at present, they require shareholders to rely on the continued charity of government, which need not from election to election decide that publicly-traded and privately-run FNM or FRE are the right way to regulate the mortgage market.  Since all shareholder rights are now vested in a federal conservator, shareholders have no grievance to sustain them if they become disappointed with future government decisions about these companies as more information comes to light about their holdings.

FRE and FNM are purely speculative plays.  Short-term, there may be great volatility that can be ridden like a bronco to profit or ruin, and I wish those cowboys the best.

However, the shares are not an investment.

No comments: