The Risk With Fannie and Freddie
AccruedInterest quotes a Merril Lynch analyst in explaining why Fannie and Freddie shareholders have far greater risk than perceived:
This is an example of where being too entangled with government coming back to hurt you. You get the benefit during good times but when things get rough, your ally, the government, may be the biggest threat to the shareholders.
It's still not clear to me if the government can force the GSEs to undertake capital injections that bankrupt the shareholders. Will this hold up in a court of law? Or are the GSEs some quasi-governmental organization where management is primarily responsible to the government? I guess the management can argue, as in the Bear Stearns case, that the company would have otherwise been bankrupt but it remains to be seen if that reasoning will fly.
The ultimate problem here is best described by Merrill Lynch's Ken Bruce. You can dive into Freddie Mac or Fannie Mae's balance sheet and make a good case that they don't need new capital, at least under current forecasts for housing. You'd therefore conclude that if they were a truly private company, they'd best serve shareholders by trying to stick it out. But they aren't a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs. The case will be made that the collective needs lower mortgage rates, and only a strong, liquid and publicly minded GSE can help bring that about.
This is an example of where being too entangled with government coming back to hurt you. You get the benefit during good times but when things get rough, your ally, the government, may be the biggest threat to the shareholders.
It's still not clear to me if the government can force the GSEs to undertake capital injections that bankrupt the shareholders. Will this hold up in a court of law? Or are the GSEs some quasi-governmental organization where management is primarily responsible to the government? I guess the management can argue, as in the Bear Stearns case, that the company would have otherwise been bankrupt but it remains to be seen if that reasoning will fly.
I think the main argument is that without the shareholder decimated infusion, FRE and FNM will be completely insolvent which, while wiping out shareholders anyways, will have some terribly rippling effects.
ReplyDeleteBut you can't prove that they are insolvent. As the quoted analyst points out, if you look at the financials, they are not bankrupt. They will only be bankrupt if you start using the "William Ackman method" of evaluation. The situation is similar to the monoline bond insurers, who according to some are insolvent but no one with any knowledge (rating agencies or insurance regulators) think that's the case.
ReplyDeleteFannie and Freddie are insolvent if and only if you mark their assets to the distressed prices that are prevalent right now. If you do not believe in efficient markets (or fair value accounting) and assume that prices are irrational right now, then they are nowhere near being insolvent.
So the question is, can management force a capital injection that wipes out shareholders where the evidence of insolvency is not solid?