Wednesday, March 19, 2008

Capital Issues: Fannie and Freddie

Two of the leading stocks in the market today are Fannie Mae (FNM) and Freddie Mac (FRE), both rallying on news that their capital requirements are being reduced to an extent that will enable them to invest another $200 billion in mortgages. The initial investor reaction as well as virtually all of the press related to this news has been overwhelmingly positive. I must admit to being a little confused and surprised by this.

First of all, as part of the press release we're being told that FNM and FRE will be required to raise additional capital. Hold on. Their capital requirements were lowered, but they need to raise more capital? The amount of the capital to be raised has yet to be disclosed, so the ultimate impact of both lowering their capital requirements and raising additional capital is a bit unclear. Regardless, lowering capital requirements during a time of distress seems quite the opposite of what common sense would dictate. Credit losses are rising and asset values are falling, so let's reduce our safety cushion! Sounds like dot-com math to me.

Why is this important? Well, their capital is essentially their cushion against a deterioration of their assets (investments and mortgage loans). Per a New York Times article, as of year-end 2007, FNM and FRE had combined capital of $82 billion. That amount supports more than $1 trillion of combined debt. If you read this past weekend's Barrons article on FNM and FRE you know that a good chunk of that $82 billion is a bit squishy and may not actually prove to be available. Also, keep in mind that combined the two lost over $5 billion last year. How big a cushion they have to weather this storm is critical. All else equal, lowering capital requirements at a time of increased default risk is dangerous.

Also, we have the issue of how these funds will be deployed. Perhaps, FNM and FRE will be able to buy mortgages at attractive prices given the lack of liquidity in the market currently. On the other hand, there is certainly a bit of political pressure for them to "help out" the subprime and distressed borrowers. If you think the credit issues we face are abating, then this is bullish as they'll be able to buy cheap assets near the bottom as well as expand their revenue and earnings. However, if you're concerned that we have a bit further to go (as I am) with this credit unwind, you have to wonder if buying additional risky assets on a potentially reduced capital base (on a percentage basis) of questionable quality is really prudent.

The other issue is government backing. Although FNM and FRE are not explicitly backed by the federal government, I don't think anyone believes they'd be allowed to fail. However, should FNM and FRE have their capital wiped out their shareholders will also be wiped out. The debt may be backed by the government, but the equity holders will get zip. Knowing this, management certainly has little incentive not to increase the balance sheet, especially given current political pressure. If they're right, they're heroes and get nice big bonuses. If they're wrong, the government bails them out (and they still probably get nice big bonuses). Not a bad risk/reward trade-off.

Bottom line: This move will clearly help provide some liquidity to the mortgage market. Will this "save" the housing market? No. But it will help at the margin. I suspect this move will also make it harder for the government to walk away from FNM and FRE should they ultimately implode. However, from an equity perspective, this latest development is unlikely to be positive if the bursting of the credit bubble has further to go. The amount and quality of their capital is critical, and there are far too many unanswered questions on this topic. Regardless of the impending capital raise, this is not the time to be lowering capital requirements. This may be marginally good for the housing market, but this is not likely to prove beneficial to shareholders.