Friday, August 22, 2008

Fannie, Freddie : Beyond the Balance Sheets

1 Kings 19:11-13

“The LORD said, "Go out and stand on the mountain in the presence of the LORD, for the LORD is about to pass by."
Then a great and powerful wind tore the mountains apart and shattered the rocks before the LORD, but the LORD was not in the wind. After the wind there was an earthquake, but the LORD was not in the earthquake. 12 After the earthquake came a fire, but the LORD was not in the fire. And after the fire came a gentle whisper. 13 When Elijah heard it, he pulled his cloak over his face and went out and stood at the mouth of the cave.”

The story of Elijah is a spiritual example of how investors need to demonstrate discipline and discernment. Each of the seemingly apocalyptic events that occurred in front of Elijah could have caused him to react prematurely or fear something not worthy of fear.

On a much more worldly level, such is the case with Freddie Mac (FRE) and Fannie Mae (FNM) preferred shares. In the past few months, the din of negative assessments of the GSEs situation has been deafening. Stories of representatives of foreign sovereign financial institutions calling Paulson himself to explicitly guarantee the US government financial backing for the FRE and FNM are accepted as truth. There has been an unprecedented selling of FRE and FNM preferred share securities, over $12B worth, in just a few weeks. For any smaller or non-government entity, this would be a sign that the corporation was worth no more than junk.

Even more telling is estimates regarding the net worth of GSEs. By many mark to market measures, there is negative net worth to the organizations. No one really disputes this, but many market participants expect that this is grounds to seek bankruptcy proceedings for these entities. The roar of the critics and investors disillusioned by the state of the credit markets expecting honest reporting and vindication for predictions of this outcome of easy credit is deafening.

Yet this is all noise. The authority, the US government has completely different agenda. The US government must maintain the stability of the US and implicitly the US housing and credit markets. The calculation of the net worth of FRE and FNM completely discounts the goodwill value of having a government organ able to keep mortgage markets from freezing up completely and starting the economy in a free fall. To the government, FRE and FNM are one of the few remaining levers to keep the markets moving. How much is that worth? In a whisper, that value is beyond the value of any bailout cost in dollar terms.

Why keep value in the preferreds and even the common then? Scream any profanity appropriate about how unfair it is for investors not to pay for their faith in insolvent corporations, but what about the intangibles? The biggest currency the US government has right now is faith that it is a good place to invest and that it will pay whatever debt is owed. A tremendous amount of the preferred securities were purchase based on the implied backing of the US government. To repudiate that assumption at this point will to risk total loss of faith in the US government as debtor. How much is that worth?

Why hasn’t the authority spoken to revive faith in these institutions and let all this noise come out speaking of their demise? In the financial classic “"Manias, Panics, and Crashes: A History of Financial Crises" the author, Kindleberger, explores how financial crises unfold and what is the options of those seeking to alleviate the crisis. A reviewer gives a synopsis of Kindleberger’s conclusion…

“What, in the end, is Kindleberger's moral? …. The solution, he believes, lies in having a lender of last resort. The trick, of course, is to avoid moral hazard and prevent the public from gambling due to the reassurance of a lender of last resort. The answer is ambiguity: the lender can come in and save the day but investors should never be certain that help is forthcoming."

Elijah never knew how many dramatic events would occur before he would hear The Lord speak. Such is the case with FNM and FRE, there is no motivation for the government to establish a floor because of the risk of inspiring moral hazard in the market is too great.

In the end, some time soon the cacophony of market opinions will subside and the market will realize that FNM and FRE serve a purpose much larger than just what balance sheets suggest. Then, at that grand final moment, the authority in this matter will honor the faithful.

Disclosure: Lockstep Investing is long FRE Y Series and Z Series preferreds

Lockstep Proposed Position: Buy FRE Y Series preferreds below $9 / share.


Lockstep said...

I got crushed on this one.

MyInvestorsPlace said...

Even more telling are estimates regarding the net worth of GSEs. By many mark to market measures, there is negative net worth to the organizations.

MyInvestorsPlace - trading, value, investing, forex, stock, market, technical, analysis, systems

Lockstep said...

I am still holding my FRE-Y position. After falling 95% after the suspension of the dividend, the stock is up 200% over the last two days. I will look for news about what has occurred to change the sentiment.