A First Look Inside the Fannie / Freddie Bailout Plan

by: Paul Kedrosky September 07, 2008 | about stocks: FNM / FRE    
Paul Kedrosky

Paul Kedrosky

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Details on the just-announced Fannie/Freddie bailout plans were initially scant, but the OFHEO and Treasury websites now have most of what you're looking for. Here is the gist:

  1. The two mortgage giants will open Monday under Treasury control.
  2. New CEOs and boards are inbound.
  3. Common shareholders are being massively diluted as preferred of a preferred/warrant deal that is being held out as offering taxpayers upside.
  4. The U.S. is now buying MBS securities direct from GSEs in the open market, and there is no explicit limit specified.
  5. The U.S. just added a planet-sized new (red) line item on its national balance sheet.

For those of you who like more words, here is OFHEO's description of the bailout's key elements:

There are several key components of this conservatorship:

First, Monday morning the businesses will open as normal, only with stronger backing for the holders of MBS, senior debt and subordinated debt.

Second, the Enterprises will be allowed to grow their guarantee MBS books without limits and continue to purchase replacement securities for their portfolios, about $20 billion per month without capital constraints.

Third, as the conservator, FHFA will assume the power of the Board and management.

Fourth, the present CEOs will be leaving, but we have asked them to stay on to help with the transition.

Fifth, I am announcing today I have selected Herb Allison to be the new CEO of Fannie Mae and David Moffett the CEO of Freddie Mac. Herb has been the Vice Chairman of Merrill Lynch and for the last eight years chairman of TIAA-CREF. David was the Vice Chairman and CFO of US Bancorp. I appreciate the willingness of these two men to take on these tough jobs during these challenging times. Their compensation will be significantly lower than the outgoing CEOs. They will be joined by equally strong non-executive chairmen.

Sixth, at this time any other management action will be very limited. In fact, the new CEOs have agreed with me that it is very important to work with the current management teams and employees to encourage them to stay and to continue to make important improvements to the Enterprises.

Seventh, in order to conserve over $2 billion in capital every year, the common stock and preferred stock dividends will be eliminated, but the common and all preferred stocks will continue to remain outstanding. Subordinated debt interest and principal payments will continue to be made.

Eighth, all political activities -- including all lobbying -- will be halted immediately. We will review the charitable activities.

Lastly and very importantly, there will be the financing and investing relationship with the U.S. Treasury, which Secretary Paulson will be discussing. We believe that these facilities will provide the critically needed support to Freddie Mac and Fannie Mae and importantly the liquidity of the mortgage market.

One of the three facilities he will be mentioning is a secured liquidity facility which will be not only for Fannie Mae and Freddie Mac, but also for the 12 Federal Home Loan Banks that FHFA also regulates. The Federal Home Loan Banks have performed remarkably well over the last year as they have a different business model than Fannie Mae and Freddie Mac and a different capital structure that grows as their lending activity grows. They are joint and severally liable for the Bank System’s debt obligations and all but one of the 12 are profitable. Therefore, it is very unlikely that they will use the facility.

And more here from the WSJ, straight from Treasury's description of the shareholder-diluting PSPA:

The Treasury said its senior preferred stock purchase agreement includes and upfront $1 billion issuance of senior preferred stock with a 10% coupon from each GSE, quarterly dividend payments, warrants representing an ownership stake of 79.9% in each firm going forward, and a quarterly fee starting in 2010.

Lots more details to come, I have to think. The market is going to initially swoon for this, but Tuesday will be interesting as the ripple effects hit.

[Update] Some related links:

  • Preferred share purchase agreement (Treasury)
  • Mortgage-backed securities purchase agreement (Treasury)
  • Wild related discussion going on over at Calculated Risk, albeit most of it inane (CR)

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This article has 48 comments:

  •  
    Sep 07 11:57 AM
    Nice job getting this up quick. I expect to see some analysis as the day goes along but I believe this will be very positive for the mortgage market. Not so positive for common and preferred shareholders.

    An immediate cut in mortgage rates would get the housing market and economy rolling pretty quickly. Let us hope.
    Reply | Link to Comment
  •  
    Sep 07 12:00 PM
    The bottom line is that every American now owns a share of some shitty 3-bedroom tract house 20 miles outside Tracy, CA and will be obligated to make its deadbeat occupant's payments but is not allowed to make any actual use of the property. Said payments will be extracted at gunpoint by the IRS. Congratulations, new homeowners!
    Reply | Link to Comment
  •  
    Sep 07 12:05 PM
    what will happen to the us dollar
    Reply | Link to Comment
  •  
    Sep 07 12:10 PM
    Interestingly, the Treasury did not specify the exercise price of the warrants... "Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price"
    Reply | Link to Comment
  •  
    Sep 07 12:13 PM
    hey jack, the same thing that has been happening to the dollar since 1913...inflation happens. fiat currency, bound to happen, but to really tickle your brain, ask why the aid package to Georgia over 1 billion, or countless others just like it over the years.....the USD is being deliberately weakened, over time, probably to make way for the Amero.

    Loose lending was encouraged for this reason, and the money top gives away USD for the same reason.

    there's my two cents.

    --I kicked myself fot not buying Bear Stearns the Friday prior to the Monday bailout announcement... I wonder what this will do to FNM and FREs' stock prices...??
    Reply | Link to Comment
  •  
    Sep 07 12:26 PM
    the usd will significantly weaken. The national debt just effectively doubled. Although it was always previously "implied", the debt was never explicitly acknowledgd before now. Paulson admitted in his speech this morning that the ambiguity was a big problem. The guarantee is now explicit, and as a percentage of gdp, the us nominal debt just doubled.....
    The greenback will likely descend, and commodities should strengthen, over the next few weeks as this becomes better understood.
    Reply | Link to Comment
  •  
    Sep 07 12:29 PM
    8,000 banks own preferreds in these 2 GSEs, representing a lot of capital to be written off tomorrow. Not to mention tens of thousands of private investors and foreign investors who own more. Your pension plans will take a hit, too. So will a lot of mutual funds. The worry over paying for that crappy house in Tracy CA is miniscule.
    Reply | Link to Comment
  •  
    Sep 07 12:33 PM
    According to the news, the total amount of preferred issued is $36 billion. Not a huge sum in relation to the $13 trillion of banking assets. Investors holding these things should know better.
    Reply | Link to Comment
  •  
    Sep 07 12:38 PM
    Also if you read their statement properly, you would know that banks holding the preferreds will be made whole. If you own mutual funds holding that junk you deserve what you get. Total losses on those securities will probably be no more than $5-10b, a drop in the bucket really. Pensions? I heard my grandfather use the word once, but I can't remember what it meant. Something about whale-oil lamps and covered wagons?
    Reply | Link to Comment
  •  
    Sep 07 12:46 PM
    Anyone who bought the common in the last 4-6 weeks deserves what they got, or don't get, it was a crapshoot and it came up snake-eyes. Anyone who has owned the stock for more that 3-5 years should have sold when the stocks were in the $50-$60 range, otherwise they were greedy and also deserve what they don't get, it has been written for many many weeks or months that the common would have zero value, and this will be close, and even the large institutions wouldn't buy any preferreds the last 60-90 days because they knew the federal gov't. would be stepping in line ahead of them, so no surprise there either. This will help the entire market tremendously, huge rally in financials coming and the market as a whole should rally big, this is a big win for those who knew how to invest ahead of this announcement.
    Reply | Link to Comment
  •  
    Sep 07 01:04 PM
    With the conservatership, are they still private companies under control of the govt or are they government entities now? Meaning, are the employees government employees now? Will the govt have to pick up their paychecks and benefits?
    Reply | Link to Comment
  •  
    Sep 07 01:23 PM
    Initially, this looks VERY bad for common shareholders. Looking more carefully at the Treasury's statements, the immediate impact on common equity value is unclear until we know the following:
    (1) The exercise price of the warrants - The Treasury left this information conspicuously unknown at this time. This can be very good or bad, depending on the exercise price.
    (2) The initial $1 billion preferred stock infusion is part of a $100 billion capacity which the Treasury is ready to inject. So the warrants with a 79.9% claim of the equity, is actually part of a potential $100 billion capital injection, not $1 bilion...which leaves the value of common equity in even greater question. Again, this can be good or bad for common stock.
    (3) the government has explicitly guaranteed that Freddie/Fannie cannot go bankrupt. In fact, the price being paid - the 79.9% warrant claim on equity, the 10% preferred interest, and complete control of the companies - does give one bone to equity holders...that is, the common will exist even in the event of insolvency.

    Source: www.ustreas.gov/news/i...
    Reply | Link to Comment
  •  
    Sep 07 01:39 PM
    We'll see what happens Monday. I'm guessing $3-$5 at the open.
    Reply | Link to Comment
  •  
    Sep 07 01:52 PM
    long term value $3-$1
    Reply | Link to Comment
  •  
    Sep 07 01:59 PM
    Looks like 80% dilution from book value of the common would value FNM about $5 and FRE about $3 (this assumes book value was misstated by 50%).
    Reply | Link to Comment
  •  
    Sep 07 02:04 PM
    Quoting the speech, Paulson alluded to "the ambiguities in the GSE Congressional charter, which have been PERCEIVED to indicate government support for agency debt and guaranteed MBS." In the last paragraph, he also says "government support needs to be either explicit or non-existent."

    My interpretation of the above is that the US government is still not obligated to fully honor GSE debt or MBS. In fact Bernanke mentioned the possibility of a "haircut" in his speech at Jackson Hole recently. Does this mean the US government has some room to negotiate the terms of payment for GSE debts and MBS? What does this do to the bond market? I hope PIMPCO's(spelling intended) Gross will take gross losses for his gross greed as evidenced by his holding GSE debt at over 60% of his portfolio.

    I would appreciate some feedback as to whether my interpretation is in the ballpark.
    Reply | Link to Comment
  •  
    Sep 07 02:09 PM
    Regardless of what the government will do printing fiat US$ and bailing out everyone who cannot or not willing to pay their financial obligations.

    There is no more need to pay off financial obligations. Why should 98% of home owners their mortgages? Now, there are no any reasons for doing so.

    The most important item: there is no more financial discipline in the USA.
    Will the USA has a recession? No.
    Will the USA has a depression? No.
    We are talking about a collapse of the entire US economy.

    As for commodities and specifically gold prices, they also were/are manipulated by Central banks: there are a lot of "paper gold" available and there are no real gold one can buy.

    Summary
    The US and EU fiat currencies based economic and financial systems are going into a very steep downfall.

    Real commodities are now the KING!
    Reply | Link to Comment
  •  
    Sep 07 02:15 PM
    Let me get this straight. The companies couldn't manage to make a profit lending us money. So now it is up to the taxpayers to bail them out. Does that mean I get to charge them interest and penalties??? What a JOKE!!! Fire them or throw them in jail. Better yet, take them for everything they own. I would bet the bastards that run the place are rich. I don't see why the taxpayers are responsible for bailing their butts out. Another fine example of a corrupt government.
    Reply | Link to Comment
  •  
    Sep 07 02:54 PM
    This, again, shows, how political Paulson acted in this mess. The government has no logic reason to take over these two GSEs other than tunnel taxpayers money into banks and rich funds. Here are some predications for monday market:
    1. FNM and FRE stocks will tank another 70%, so if you like, short the money managers who own FNM and FRE, (LM, if they still have)
    2. Debt, MBS issued by Freddie and Fannie will rally.
    3. Bank stocks will rally due to most of them have item2.
    4. Treasury will be sold off due to the liability added to US government

    The house turmoil has nothing to do with FRE and FNM, so if Paulson argue that they acted in an unsafe way, does that mean Paulson will tighten the lending standard? if he does, then no liquidity is added, If he doesn't, then FRE and FNM will lose more money, taxpayer will pay the bill. Either way, the banks and institutions who own the debt or MBS issued by two GSEs will have better balance sheet, because essentially what they have are treasuries debt with higher yield.
    Reply | Link to Comment
  •  
    Sep 07 03:08 PM
    "Creditatrisk&quo... how can you say :This, again, shows, how political Paulson acted in this mess. The government has no logic reason to take over these two GSEs other than tunnel taxpayers money into banks and rich funds. Here are some predications for monday market:


    That is the most unknowledgable statement I have read, do you have any idea how many foreign banks and gov'ts. own the debt of these 2 companies, do you have any idea how much of this debt is owned by institutions like pension funds, and municipalities that would be insolvent if the debt went to 50 cents and the interest payments were defaulted on, what do you think would happen to small investors that own gov't agency bond funds that would drop by 50% and would force those elderly and conservitave investors to become bankrupt and cut their income streams, it's not about helping the "Rich funds" it's about keeping the financial system solvent, look at the big picture and stop lamenting how "rich folks" are helped, thinking like that will never allow you to become one of "them" the rich folks.
    Reply | Link to Comment
  •  
    Sep 07 03:10 PM
    Non event for the dollar, this was largely in the market. The only piece unexpected was whacking the pref dividends. They will obviously trade down, forcing hundreds of banks to write down capital, bear's 10b number sounds right. But when you ripple 10b in capital write downs it pulls 15 times that in withdrawn lending. FNM and FRE equity holders have had all rights suspended and are massively diluted, they will open lower.
    Reply | Link to Comment
  •  
    Sep 07 03:25 PM
    Would SKF (ultra-short financial) be a good play considering the diluted shares? Any views out there?
    Reply | Link to Comment
  •  
    Sep 07 03:44 PM
    Bill Miller must really be enjoying his weekend.
    Reply | Link to Comment
  •  
    Sep 07 03:52 PM
    tk6910 - no, completely wrong, this is exactly intended to make the bondholders whole, and payments will continue - ahead of the treasury's preferred - on even the subordinated debt. The bondholders will not be touched. That is kinda important, because they include oh, little folks like the central bank of China (foreign central banks own $1.6 trillion in agency paper) and any default on a dime of that would have made the credit of the US worthless for generations across the entire world.

    As for the idiots discussing who gets how many dimes and whining about it, buy a clue already. You'd be a soup line tomorrow if this weren't done. The issue is whether the mortgage market functions at all - nobody else is lending anything - and with it, whether anyone can sell a house, at any price - and with that, whether there *is* a US economy or just a big smoking hole in the ground.

    I hate whiners.
    Reply | Link to Comment
  •  
    Sep 07 04:21 PM
    I am confused on how America can keep propping itself. What exactly do we do for other countries? We borrow money from China so we can consume their goods and buy our houses... We use others money to buy vast amounts of oil... What do we offer in return? Why do companies keep borrowing money to us? We can't take every one on in a global fight. So what does the world fear in saying no?
    Reply | Link to Comment
  •  
    Sep 07 05:44 PM
    "...., do you have any idea how many foreign banks and gov'ts. own the debt of these 2 companies, do you have any idea how much of this debt is owned by institutions like pension funds, and municipalities that would be insolvent if the debt went to 50 cents and the interest payments were defaulted on, what do you think would happen to small investors that own gov't agency bond funds that would drop by 50% and would force those elderly and conservative investors to become bankrupt and cut their income streams, it's not about helping the "Rich funds" it's about keeping the financial system solvent, look at the big picture and stop lamenting how "rich folks" are helped, thinking like that will never allow you to become one of "them" the rich folks."

    First there was Chrysler, then the Savings and Loans fiasco, Bear Sterns, now the bastard Mae & Mac siblings, and GM is currently on its knees begging for a public bailout. Pathetic. Just more and more examples of private profits and public debts. And who was being named one of the new heads, a Merrill Lynch exec, the same company that foisted Don Regan upon the public, one of the men who begat the S&L crisis. Just another example of the criminal financial elite circling their wagons behind their walls and their gated communities.

    Ya know, I don't really care about foreign banks that made bad investment decisions, something I have done myself a few times. I have never been part of a pension plan so I don't care about those who have relied upon a third party to cover their retirement. But again, I too have lost money in some investments in my retirement account and I take full responsibility and ask for no bailout. If my municipality would default on a single investment blunder than we deserve what we elect, and that which is proffered up for elections is overwhelmingly doggy doo doo. And as hard as I try, I can't think of a single fellow blue collar working class schmuck like myself who owns a government agency bond fund. But again, although I would feel sorry for a small investor who owned such investments, it is not like I haven't also made some poor investment choices. But I take sole responsibility for my mistakes and don't ask or expect any bailouts. If a single investment represents financial ruin then I have little sympathy.

    So from the perspective of a fairly typical middle class worker who has been honest with his taxes and has stayed out of debt by not subscribing to rampant consumerism, yea it looks to me it is all about protecting the wealthiest by covering their losses, due to their own mistaken judgments, with public funds and then trying to scare the masses by having them think that if the public does not bail out the wealthy then they will be the ones to suffer. I don't buy it!

    I really doubt that the entire system will collapse, but I am sure that those whose welfare and fortune are tied to "the system" are indeed in fear that their little profit puppy might die. And I understand that for some of you, it is impossible to understand that there are those of us who do not aspire to be like "them".
    Reply | Link to Comment
  •  
    Sep 07 05:45 PM
    thoroughbred, I don't think they need to be rescued, at least not now. They can still function well, just look at the recent debt issuance. The big problem with FNM and FRE is the default rate of the loan portfolio they have. Will these default rate goes down with Government taking over? obviously not! It has nothing to do with whoever manage the company. They can only change the future lending practice, but like I said, the government cannot tighten up the lending standard neither. So why would Paulson make this decision with couple of months left in his tenure? It doesn't matter the foreign government owns the MBS or bonds, as long as Paulson's friends own portion of them, it worth for him to do something to help out. And in fact, if the GSE's doesn't fail, which is very likely even without government intervention, the spread problem with these MBS will narrow again, and no lose will be occurred to pension fund which tend to hold these securities until maturity. Only those trading companies have to mark the temporarily loss which benefit most in the government taking over.
    Reply | Link to Comment
  •  
    Sep 07 06:44 PM
    SKF will go DOWN if the financials rally, which I think they will now do, so NO to SKF, look at IYF, IYG and IAT for upside. They don't necessarily need a "bailout" but they need the expressed backing no longer the implied backing of the gov't to protect the value of their debt, which is held by all the secondary instituitions I mentioned before. This is a positive all around, it should have been done 2-3 months ago. And for those that don't care about foreign gov'ts. without the foreign gov'ts, buying the debt we sell our interest rates would be back to the Carter era rates of 18-20%, so to not care about anyone else but yourself is very narrowminded.
    Reply | Link to Comment
  •  
    Sep 07 07:18 PM
    Kudos for the govt plan, as hard as it is for a free marketer to swallow. It covers as many of the open bases as could be covered. Bondholders intact, so no foreign govt runs. Preferred holders scalped but banks can apply for relief regarding capitalization, so FDIC won't look all that much weaker. Common holders OTL, but that's life. Pretty pathetic, but beats standing on the street corner with a tin cup. And 10% return for the taxpayer is about commensurate with risk. Now then, mighty government, let's see how the 800bn swallow in bad MBSs and CDOs generally goes in 2009.
    Reply | Link to Comment
  •  
    Sep 07 07:29 PM
    Is it just me or is anyone else reminded of a situation about 24 years ago with the Continental Illinois National Bank? Read Belly Up or The Continental Affair as both books do a nice job of describing the government's bailout. Interestingly, the government also took 80% of the institution in that instance and as the FDIC states on their website, "...the permanent assistance plan also infused $1 billion in capital into the bank through the FDIC's acquisition of preferred stock in Continental Illinois..." Deja Vu all over again?
    Reply | Link to Comment
  •  
    Sep 07 07:57 PM
    A few (very few) bright comments here - Old Turk, I am with you. You can read my article that was published this morning ("Forget the Moral Outrage....".

    This plan is good in terms of accomplishing the objectives of stabilizing the market and buying time to get out of this mess (and time will fix this mess).

    For those of you who can't read apparently, the government hasn't assumed the debt. In fact, it has capped its exposure at what I believe is WAY above a level necessary to sustain the GSEs. As I wrote on Seeking Alpha, the bailout of FNM and FRE is how this bear market was going to end (yes, I was calling it a bear market over a year ago). For those of you who like to invest with mirrors, go ahead and try to find some big negative here. You will be able to sell your stocks higher tomorrow, at least on the open, as a MAJOR overhang on the market is being lifted.

    As far as the value of FNM and FRE goes, one can never tell where a stock will trade when such a cataclysmic event occurs. The dilution was greater than I expected, and the mandated asset reductions (which will take until 2020 to accomplish) greatly diminish the value of the stock. My initial calculations (and this assumes that the warrants have an exercise price of 1-3) is that the stock is worth about $9 or $10 a share in 2013. If one discounts it back at 16% per year, that works out to about $4 per share. Can it trade at 1? I hope so - I am a buyer. Can it trade at 8? I hope so, I am a seller.

    Keep in mind that the equity wasn't wiped out for a lot of reasons, not the least of which is that the government could make an absolute fortune on this deal. Politically, it will look very bad if the stock surges - the massive dilution pretty much limits that possibility. The government has to "sound" as punitive as possible (and they were punitive). So, my best guess is that the range tomorrow is 3-6, while the rest of the market soars incredibly and justifiably.
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