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07/13/2008

Fannie Mae Is Saved! It's Shareholders ... Not So Much.

As I chronicled in my last post about Fannie Mae's Golden Goose, the struggles of Fannie Mae and Freddie Mac were clearly putting to the test the bond market's long held assumption that both companies had the implicit backing of the US Government and were "too big to fail".

With tonight's announcements from the US Treasury and the Federal Reserve, it looks like the bond market was right all along and much more credible that the consistent denials of Washington's politicians (imagine that!).  After tonight's action there's nothing implicit about the government's guarantee of Fannie and Freddie's debt; you might as well print in on the legend of their bond certificates and take it to the bank (or perhaps the Fed).

Be Careful What You Celebrate
There are probably a lot of cheers going through halls of Fannie Mae's Georgian-style mansion on Wisconsin Avenue tonight, but before they crack open the bubbly, they might want to read fine print of today's press releases, because while Fannie and Freddie will indeed survive to live another day, they will be living in a very different world.

Specifically, as part of getting the Fed to sign off on this rescue package, the Treasury and OFHEO have (undoubtedly at the Fed's insistence) agreed to give the Fed "a consultative role" in "setting capital requirements and other prudential standards".  For anyone who has followed the Fed's view of the GSE's over the past 15 years, this means the party's over for Fannie Mae and Freddie Mac.

Payback Is A Bitch
The upper echelons of the Federal Reserve, including almost its entire Board of Governors are typically populated by very serious economists, almost all of whom have PhDs and illustrious academic careers.   Fed economists tend to be very smart, very logical, and very cynical.  Thus they have for some time understood the huge moral hazard inherent in the basic structure of Fannie and Freddie.   This is why both Bernanke, and Greenspan before him, have been one the few voices in Washington DC consistently almost literally begging politicians to reign in both agencies.   Up until now, those pleas have largely fallen on deaf ears thanks to the masterful political coalitions built by both Fannie and Freddie.  That Fannie Mae and Freddie Mac fended off the Fed, arguably most Washington's most powerful independent institution, for so long is a true testament to the power of the political coalitions that they built.

Unfortunately, for Fannie and Freddie, those political coalitions are currently collapsing at light speed as politicians run as fast as they can from ground zero before Fannie and/or Freddie go super-critical. Fannie and Freddie now not only find themselves without their vaunted political air cover, but at the mercy of one pissed-off Fed.  Economists are generally not prone to anger, there's very little utility in that, but my guess is that there's a fair amount of anger going around Fed these days.  Anger that none of the politicians listened to them, anger that Fannie and Freddie consistently thumbed their noses at them, and anger above all else that they are currently stuck cleaning up a mess they warned everyone who would listen would one day come their way.

So how might the Fed translate this anger into policy now that it has officially been given, at least partial, control of Fannie and Freddie's regulatory leash?  To get some insight into that one need only to read a speech about Fannie and Freddie from Chairman Bernanke just over a year ago.  Indeed, the final paragraph gives good sense of what the future has in store for Fannie and Freddie:

Legislation to strengthen the regulation and supervision of GSEs is highly desirable, both to ensure that these companies pose fewer risks to the financial system and to direct them toward activities that provide important social benefits.  Financial safety and soundness can be enhanced by giving the GSE regulator capital powers comparable to those of bank supervisors and by creating a clear and credible receivership process that leads debt holders to recognize that they would suffer financial losses should a GSE fail.  Finally, the Federal Reserve Board believes that the GSEs’ investment portfolios should be firmly anchored to a measurable public purpose, such as the promotion of affordable housing.  I believe that this approach provides a reasonable balance of social costs and benefits for the GSE portfolios. In particular, this approach would re-focus the GSEs on the affordable housing objectives given to them by the Congress.

Before you react to this, consider that this speech was made over a year ago when Fannie Mae's stock price was 5 times higher and its powerful political coalitions were still fully intact making any attempt at criticism a rare, brave, and largely futile endeavor.  Once one gets past the obligatory genuflections to "affordable housing", the Fed's prescription in this speech is clear:  they want to kill Fannie and Freddie Golden Gooses, i.e. they want to dramatically reduce their $1.5TR mortgage portfolios to a small fraction of their current size and return both companies to their original mission as a conduit and guarantor with maybe a few "investment" dollars thrown in to grease the skids of the only the most politically sacrosanct areas of the mortgage market.  In short, the Fed intends to replace Fannie and Freddie's regulatory leash with choke chain and then proceed to pull it ... very hard.

Say Goodbye To The Golden Years
For taxpayers, this is largely good news as it will likely result in far smaller balance sheets at Fannie Mae and Freddie Mac with far lower potential for a (another) costly bail-out.  For consumers this is probably slightly negative news as the absence of the agency's "risk free" buying binges will probably lead to slightly higher mortgage rates. For Fannie and Freddie shareholders, beyond Monday's likely relief rally, this is long term bad news because it means that the government is killing off the agencies golden gooses and therefore the companies are never likely to return to the halcyon days when their biggest concern was making too much money.

All that said, given Fannie and Freddie's prior political and economic comebacks it's entirely conceivable that they will be able to weather the storm and then refashion a political consensus that allows them to get back to the good old days (up until Friday they were doing pretty well).  But even politicians are once bitten are twice shy, so it may be awhile before Washington DC forgets enough of today's pain to let the GSE's take another free-ride on the government guarantee express, and if the Fed has its way, that train will never leave the station again.

I currently have no investment position, long or short, in Fannie Mae or Freddie Mac.  This is not investment advice. Please see my disclaimer at the bottom of this page for further details.


July 13, 2008 in Wall Street | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.