Fannie, Freddie Shares Rally; Nationalization Fears Ease
You know what, maybe we were all a little premature on this nationalization talk. That's the emerging sentiment among investors, at least, and one now also being pushed actively by analysts with a better grasp of the debt markets that really drive both Fannie Mae (FNM) and Freddie Mac (FRE); as a result, shares in both GSEs rallied strongly both Tuesday and Wednesday after a horrible past week. Fannie closed Wednesday up 15.3 percent to $6.48, while Freddie moved up 19.65 percent to $4.75. The wild roller coaster underscores just how fragile sentiment is among equity investors these days, despite relatively more steadfast sentiment within the debt markets during the past week. As HW reported on earlier this week, Freddie’s $2 billion auction of short-term debt was met with strong demand Monday, while similar strong demand characterized a similar debt sale by Fannie on Wednesday. Some market observers had speculated earlier this week that strong demand for the GSE's short-term debt may have been an artifact of a potential buy-n-flip opportunity involving the Fed's discount window, a theory that HW's sources in the market have deemed highly unlikely. "It's elegant math, but doesn't fit within the type of distribution we're seeing in actual flows at the discount note windows," one analyst told HW via email on Tuesday evening. "There are billions of short term agency securities going to real, domestic accounts managing hoards of scared, short-term money. Arbs can pick money up in dozens of other places without stooping to the auctions of 6-mo discos." Linda Lowell, a 20-year ABS/MBS market participant (and frequent HW contributor), noted in her column at Market News International on Wednesday morning that investors waiting for a government takeover of either GSE shouldn't hold their breath. "The [Treasury] backstop was meant to reassure debt and MBS investors -- especially sovereign funds and other foreign investors," she wrote. "However, in the format leaked to the press, this plan was construed as an imminent rescue at taxpayer expense and only fed the markets panic." "Clearly the media is reading its own copy -- or should I say, drinking their own home brew. The Treasury hasn't stepped in because at present there is no indication that either Fannie or Freddie is unable to continue operating without Treasury assistance." That home brew? Probably Kool-Aid. As Lowell notes, both GSEs have been reserving heavily for future losses; it's a move that hits current income when reserves are set aside, but future credit losses don't then also hit income. Analyst Jim Vogel at FTN Financial put it succinctly in an earlier client update when both GSEs reported Q2 earnings; at that time, he suggested that in any other market, reserving activity would be seen as prudent risk management. "When the actual cash losses occur -- and the peak is expected by the enterprises and most external analysts in 2009 -- the charge will hit loan loss reserves, NOT income," wrote Lowell in her column. "Assuming Fannie and Freddie have conservatively anticipated default and severity, some of those reserves may even be recaptured as income in later years." A recent report from Citigroup Inc. (C) analyst Bradley Ball suggested similar sentiment. In a report put out last Friday, Ball characterized the most recent sell-off of shares as "surprising, since the only catalyst was apparently a press report suggesting that federal officials are likely to recapitalize the GSEs soon." He said that any nationalization of the GSEs was "unlikely," although he did allow for the potential for a "Chrysler-like Federal loan." The report also stressed that shareholders' interest would likely be preserved, regardless, although Ball said that any near-term Treasury action was highly unlikely. "We are not convinced that Treasury needs to take any action over the near-term," the report said. "While the decline in the GSEs’ stock prices, if they persist, may pose challenges to any capital raising efforts down the road, the short-term stock price performance does not have any bearing on the success of the 'Paulson Plan.'" In other words: everyone, just calm down. That's not to say there aren't GSE detractors, arguing for nationalization, or those who believe the capital situation may be more dire; but HW's sources have suggested repeatedly that such sentiment is often based in a failure to understand the GSE's business and/or a political agenda. For example, in its monthly summary for July, released Tuesday, Fannie Mae reported $103.6 billion in liquid investments -- a $31 billion increase from June alone (Freddie does not report similar statistics). FTN's Vogel and others have suggested that this point alone should serve to end the debate over immediate capital adequacy. That's not to say the GSEs don't have capital constraints; they most certainly do, and those constraints are being seen in how Ginnie Mae has vaulted in front of both Fannie and Freddie in fixed mortgage security issuance during August. But most analysts well-versed in GSE watching have suggested that both companies could continue to operate in the current adverse credit market and maintain current reserving activity without putting current regulatory capital requirements at risk at least through the end of this year, or perhaps even longer. Even then, as Citi's Ball suggested, the GSEs are not without options; among them, HW's sources said, is the ability of both GSEs to allow portfolio assets to run-down. While not necessarily the best outcome from a mortgage lending perspective, such a run-down would offer plenty in the way of liquidity; which means that any debate over the GSEs shouldn't be about solvency or a nationalization that seems increasingly unlikely to take place any time soon. Instead, sources said, the debate should be over how to best support the home ownership objectives that are at the core of each entity's respective charter. Disclosure: The author was long FRE and held no other relevant positions when this story was published; indirect holdings may exist via mutual fund investments, as well. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.