Fannie, Freddie Socked by Investor Paranoia
It doesn't take much to knock a company's stock into the abyss in this sort of unsure financial market -- witness the fate Monday afternoon of twin government-sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE) as the latest case studies in what is clearly an increasingly jittery market. Shares in both GSEs were clobbered Monday largely after a warning from a Lehman Brothers Holdings Inc. (LEH) said that both GSEs would need to raise as much as $75 billion in fresh capital. But was the warning correct? Some of HW's sources on Monday accused Lehman of "factless fear stoking" in discussing the analysis in the report. "Given the scrutiny the markets are under, Fannie and Freddie in particular, it's irresponsible to put something like this out without having clearly done your homework," said one source, a bank executive that asked not to be named. In a note to clients, Lehman analyst Bruce Harting sounded the horn around a possible revision to FAS 140, which governs the accounting treatment of off-balance sheet entities; a proposed update to the accounting standard by the Federal Accounting Standards Board would eliminate the concept of a qualifying special-purpose entity, or QSPE -- a unique kind of off-balance entity that critics have said is to blame for current market woes. That FASB is looking to eliminate QSPEs shouldn't have been news; it was something HW first reported on way back in February, despite the breathless coverage the issue has gotten recently. QSPEs largely fueled the private-party securitization boom around mortgages, and the FASB proposal would force billions of dollars of liabilities back onto the balance sheets of key financial institutions, most of them on Wall Street. Harting went further, and suggested in the Lehman research note that Fannie and Freddie may also need to bring billions of dollars of mortgages back onto their balance sheets were the FASB 140 revisions to be implemented. Cue widespread investor panic. Shares in both Fannie and Freddie fell more than 20 percent almost instantaneously on the news. Harting went so far as to suggest that Fannie and Freddie would get an "exemption" from the rule, because "they would be so undercapitalized under the new rule it would be nearly impossible for them to raise enough cash." Shares seemingly fell by second as investors read each word. HW's sources, however, took issue with Harting's characterization of the impact of FAS 140 to the GSEs, and said that the securitization structures used by both Fannie and Freddie largely qualified for so-called "de-recognition" -- that is, for off-balance sheet treatment -- under the proposed revisions to FAS 140 guidelines. "[The GSEs] are reporting entities and subject GAAP like all others," said one source via email, "but the description of securities that qualify for derecognition [under proposed revisions to FAS 140] matches pass-throughs to a tee. "GSE paper is of course Q now, and will be eligible in the future." HW's sources told us that the proposed revisions to FAS 140 exclude securitizations in which all interests have "equal claim" -- essentially, the definition of a traditional pass-through security, as well as any REMICs backed by MBS. While some GSEs, particularly Fannie, have issued structured securities that mimic the (ahem) more creative structuring seen in the private-party market, our sources said the handful of such securities would be a "drop in the bucket" relative to the less exotic structures that make up the bulk of each GSE's securitized portfolio. That's not to say that Fannie and Freddie are in the clear; each faces other, more bona fide ills that clearly contributed to the cliff diving observed on Monday as well. Among them: concerns about future credit losses in both GSEs' books of business, as well as worries about increasing exposure to downgraded mortgage insurers. Both are very real and material concerns that seem likely to pressure earnings from both GSEs in coming quarters. Wrong time, wrong place It now seems likely that Freddie's decision to wait before embarking on a capital raise -- by following the disciplined, but not legally required, path of registering with the SEC -- may prove to be an instance of being in the wrong place at the wrong time. In May, when the company first announced its new equity plans, the market was still enjoying follow-through of the Bear Stearns & Co. relief trade. Fannie Mae got its capital raise off without difficulty; by sticking to its timetable, in contrast, Freddie has seen its share price almost halved. Today's tanking trade likely won't help matters any. As the share price falls, Freddie must issue more shares to raise the same new capital; and the more new shares issued, the more dilutive the issue is for current shareholders. So far, Freddie is close to the timetable suggested at its May earnings conference. But hurdles remain. Margaret Kerins, agencies analyst at RBS Greenwich Capital, noted in a recent research note that finding a new CEO (required to separate the CEO and chairman posts currently held by Richard Syron) is proving to be a tough project, given the growing number of open financial CEO spots at large financial firms. Approaching second quarter earnings announcements can get in the way, too, as Freddie enters the "silent period." Not surprisingly, earnings information "would be considered material for anyone interested in purchasing the capital," Kerins said. Taken together, these concerns seem likely to push the timing of a capital raise -- assuming a CEO is on board, and the SEC registration complete -- into August. What condition will Freddie's stock be in by then? The answer may depend on which analysts investors choose to listen to. Disclosure: The author held no positions in FNM or FRE when this story was originally published. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.