FYI | Sep 08 2008
By Greg Peel
Nobody claims to have heard the rifles. All we know is sometime on Sunday in the US Richard Syron, CEO of Fannie Mae, and Danial Mudd, CEO of Freddie Mac, were led quietly away.
Their crime? One might say abuse. But just how much blame can be laid specifically at the feet of the chief executives of two institutions that were neither truly private nor truly public, who’s brief was to provide cheap mortgages to American taxpayers on a government imprimatur while at the same time provide a profitable investment for private shareholders? Was this structure ever really tenable, and was it not set up with the opportunity to be abused from the moment of “privatisation”?
(Kevin Rudd please take note. And then take another look at Telstra).
Last night the US government stepped in and effectively seized control of America’s two government sponsored mortgage lenders, Fannie Mae and Freddie Mac. With powers provided to it recently by Congress, the US Treasury is set to acquire a new form of capital in the institutions. This “senior preferred” stock will rate above both existing preferred stock and common stock. As all subordinated debt will be honoured, existing preferred shareholders now rank above only common shareholders for any profits left over once all debts are honoured and the senior preferred shareholder – the government – has been paid.
In formulating the plan, Treasury secretary Hank Paulson was mindful of not being seen to bail out the shareholders of Fannie and Freddie. It is mortgages, not investments, the government needs to protect and needs to be seen to be protecting. Paulson would also have been mindful of such a bail-out – a nationalisation by any other name – is anathema to the tenets of the Bush Administration’s Republican party and its conservative, free market credo. But to not act would have been to risk the stability of the entire world financial markets. Said Paulson:
“Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans, and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation.”
On that note, the common and preferred shareholders are now effectively wiped out.
What has not been acknowledged directly by the government is the amount of Fannie and Freddie debt being held outside the US. While common and preferred shareholders include most US banks and pension funds, bonds issued by the mortgage lenders to fund their portfolios are to a great extent owned by the central banks of China, Middle Eastern nations and, most ominously given recent developments, Russia. No one would have liked to contemplate what might have transpired had Fannie and Freddie been allowed to go into bankruptcy, forcing the central banks of America’s allies and potential enemies to have to line up for a few cents in the dollar.
The bail-out is arguably the largest in US corporate history. Such a policy move is a very significant one in the eleventh hour of the lame duck Bush Administration, but both presidential candidates – McCain and Obama – were briefed on the plan and provided approval. One of the two will inherit Fannie and Freddie.
One element missing from the plan is a specific estimate of just how much this bail-out might ultimately cost the US taxpayer. Step One is simply for F’n’F to each issue US$1bn in senior preferred stock to the government at an interest rate of “at least” 10% per annum in exchange for a guaranteed US$100bn each to cover future losses. The government also acquires warrants (call options) to buy 80% of the common stock of each company at a “nominal price”, or less than US$1 per share. At the official close of trading on Friday, Fannie shares were marked at US$7.04 and Freddie shares at US$5.10.
Common shareholders have no recourse. From the moment the bill was passed through Congress allowing the government to step in “if need be” the possibility of a full nationalisation was on the cards. All trading since has been on a speculative basis. Financial analysts at various broking houses have not helped, recently suggesting F’n’F may have enough capital to muddle through. Wrong again.
On top of interest paid to the government on the senior preferred stock, commencing 2010 a quarterly fee of an amount yet to be determined will be paid for any financial support the government ultimately provides. This is the payment for the US$100bn each – and most expect this will only be the start of many more billions to come – the government will put up. The date allows a window of grace to allow the lenders to rationalise, but it is also timed beyond where most analysts see the US housing market having reached bottom, being some time around mid-2009.
In the short term, this is a rescue package. In the long term, the ongoing existence of the “government sponsored enterprises” is unlikely. Another caveat within the package is that from 2010 on the two must reduce their own investment portfolios by 10% a year. This is akin to telling an insurance company to start winding down the investments it holds against potential claims. In other words, the government has begun a process of winding down the two companies altogether.
The irony in all of this is that the Federal National Mortgage Association (FNMA – say it quickly) was created by the US government following the Great Depression as a means of providing affordable mortgages to Americans who were trying to fight their way back. At the time banks were suspicious of lending to each other, and thus mortgage rates were unaffordably high for those already hit by economic hardship.
Sound familiar?
The entity became a great success as a policy move, and by the time the US had reached true global economic hegemony in the sixties the free market credo kicked in. The FNMA was privatised and listed on the stock market. Thus was born “Fannie Mae”. As such an entity could not, under the free market credo, exist as a monopoly, the Federal Home Loan Mortgage Corporation was also created as a twin entity to offer competition. It became known as Freddie Mac.
The two remained as “government sponsored enterprises”, but the implication of such sponsorship was somewhat misleading. The government had no direct involvement whatsoever and provided no funding. But it was understood that the government “supported” the two mortgage lenders. In exchange, Fannie and Freddie could provide only “conforming” loans on a capped value (most recently US$417,000) and on reasonably stringent lending standards. Hence the great bulk of F’n’F mortgages are “prime”, although there are a small proportion of adjustable rate mortgages (considered “mid-prime”) and an even smaller number of “subprime” mortgages in the portfolios.
The bottom line is that F’n’F mortgages were considered to be low risk. When the entities bundled up and securitised these mortgages by issuing bonds they were rated AAA. Why not? Somewhere in the background stood the US government. As a result, F’n’F were able to secure cheaper funding for their businesses as debt buyers were prepared to pay more for the bonds (lower interest rate). In turn, F’n’F could offer Americans cheaper mortgages than banks and other lenders, provided those mortgages “conformed”.
So what remained after privatisation was not particularly different to the initial nationalised entity created after the Depression. But now there were shareholders as well as debt holders. And how often do we now hear that cold-comforting mantra “we must do the right thing by our shareholders”? And in retrospect, weren’t F’n’F just a licence to print? Cheap funding, implicit if not explicit government guarantee, competitive product. And no more than a duopoly. If you couldn’t make money out of that you weren’t really trying. But the greater risk is that when an acrobat works with a safety net, he becomes a lot more brazen.
From the time the credit crunch froze mortgage lending markets last year, Fannie and Freddie have accounted for around 70-80% of all new mortgages issued in the US. While banks and other lenders have been forced to severely tighten their lending practices in light of a now defunct securitisation market, and crippling suspicion between entities, Fannie and Freddie have marched gaily on. They have all but taken over the market safe in the knowledge that if it all went pear-shaped, well, the government can always step in. Mortgages are all the twins do. The whole global credit crunch has its roots in the US housing market. How could F’n’F still be conducting business as if nothing ever happened?
The truth is the two have written down some US$14bn in investments. They are responsible for half of all US mortgages, or some US$5-6 trillion in value. Under government sponsorship they have been able to operate on the skinniest of margins to capital held. All other lenders need to satisfy strict capital adequacy requirements under the US Federal Reserve’s lender of the last resort facility. Only last month, Freddie Mac’s CEO was boasting that the company had never had as much capital in its history. As flagged by FNArena at the time, that was the point at which we knew it was all over. The most recent precedent was the Bears Stearns CEO claiming the investment bank had plenty of liquidity, one day before it went under.
To make matters worse, the top executives of both lenders have long enjoyed enviable salaries, and have continued to draw such salaries even as the share prices have fallen 90%. Every other lender has been forced to take remedial measures – raising expensive emergency capital, scrapping dividends, laying off thousands of staff, replacing CEOs – but F’n’F have powered on. Had anyone heard the gunshots, there would have been few tears. Ironically it was only a few years earlier that both companies had to pay out massive fines having been found guilty of producing fraudulent financial statements.
Financial institutions like to finger their “rogues” – it relieves responsibility. Syron and Mudd will go down in history as the CEOs that brought down Fannie and Freddie. Yet are they solely to blame? Leave a kid alone in a candy shop and that kid cannot be held responsible for its actions. Give two companies a government guarantee to make extraordinary profits unattainable by the private competition and you’re setting up for a fall no matter who the CEO’s are.
Then consider that guarantee is backed by the world’s reserve currency – a currency that has been nothing more than a paper IOU ever since the Vietnam War sent the US government broke. Throw in a Fed chairman who cuts the cash rate down to 1% as a response to terrorism and suddenly you have a housing bubble. Like any bubble, it was one where prices could never go down again. If ever there was a utopian playground for little Fannie and Freddie, this was it.
But here we now are, back in the 1930s. With the benefit of hindsight, the US government made a big mistake back in the sixties. You cannot have an institution that is both private and public at the same time. Witness the number of failed public-private partnerships even in Australia. Private profit – public cost.
Just how much will the bail-out of Fannie and Freddie end up costing the US taxpayer? Well the long term intention is nothing. Indeed, the hope is that one day the taxpayer will actually make a profit, for under the normal operation of mortgage lending it should. But the short term cost will be extreme. Success relies entirely on the US housing market finally stabilising and normalcy returning to the business of lending.
Paulson is right. To do nothing would have meant disaster. There are those in the US and around the world who will rail long and hard that the bail-out only perpetuates a system which is clearly broken. In a perfect free market Fannie and Freddie would be allowed to fail. But the ramifications of such failure are just too dire. The result could have meant the Great Depression would prove as ill-named as the Great War of 1914-18.
From a stock market point of view, this bail-out should effectively prove the first real step in stabilising global financial markets. Cutting the US cash rate has had no effect. Bailing out Bear Stearns now seems like an insignificant curtain raiser. The emergency collateral swap facilities provided by central banks across the globe have also been largely ineffectual, and subject to abuse. This bail-out will provide an impetus for stability in shares in financial sectors across the globe.
It should also provide an impetus for the gold price, as the flipside of the undermining of the value of the US dollar as precipitated by the bail-out. But in the case of the US dollar it is a two-edged sword. While the nationalisation of Fannie and Freddie will cost the US government dollars it doesn’t have (but can print at will) the action may yet stabilise the US economy and allow confidence to return. If that proves the case, then the US dollar should not collapse. It may, indeed, return quickly to recent strength.
“History never repeats / I tell myself before I go to sleep” – Tim Finn.
