We take this opportunity, as second quarter earnings continue to be reported, to view the problem of government-backed loan viability now that we are a couple weeks removed from the initial impact. Joining us is Director of Zacks Equity Research Dirk van Dijk, CFA for his viewpoint on this issue, and how its affects will be felt going forward.
Now that there has been some time to assess the fate of Government Sponsored Enterprises (GSEs), what is your take going forward?
The shares of the two giant GSEs, Fannie Mae (FNM) and Freddie Mac (FRE), have been in an absolute freefall over the past few weeks. We have long warned that the attempts to put the burden of the mortgage crisis on the GSEs was misguided and would eventually put the two of them in peril. However, since the two have a special relationship with the government, and as of a few months ago, appeared to be relatively healthy, the temptation just proved to be too great.
These moves included things like the expansion of the cap on the size of the mortgages the two could buy and encouraging them to insure more mortgaged backed paper than they already did. Now the market is convinced that they are both severely undercapitalized, despite assurances from regulators that they still meet the required capital levels. If mark to myth accounting is used, they do.
That's "mark-to-myth," but what if you consider "mark-to-market"?
If mark-to-market accounting is used, it seems very clear that they are very undercapitalized. Even though the underwriting standards at the GSEs were generally better than for the private label mortgage backed securities that have already blown up, in retrospect they have proved to be too loose. In part, this was because FNM and FRE relied on private mortgage insurance from firms like PMI Group (PMI) and MGIC (MTG), which now appear to be on the brink of insolvency themselves. The rules for GSE mortgages were that you had to put down 20%, or have private mortgage insurance, but if the mortgage insurance firms go under, well then, so much for that first loss protection.
Hadn't GSEs been considered quite solid for a long time?
Before the accounting problems cropped up, the GSEs had posted extraordinary growth. They effectively replaced the Savings and Loan industry as the prime source of mortgage finance after the trouble that industry ran into in the late 1980’s. The GSEs were always far more leveraged than commercial or even investment banks. They could get away with extraordinary levels of leverage because of an implied guarantee from the government. Both firms are posting large losses in the second quarter, further reducing the equity.
How does the soft housing market factor into this, looking ahead?
The collapse of the housing market has brought down the values of houses across the country. It has hit the value of houses with imprudently underwritten mortgages, prudently written mortgages, and indeed the value of houses with no mortgages on them at all. As people become farther and farther underwater with their houses, they become that much more likely to default on them.
The fact that wages are not rising anywhere as fast as the cost of living, especially for necessities like food and energy, has not helped matters. Similarly, the loss of a half million jobs or so since the start of the year is not helping homeowners' cash flow. As delinquencies and foreclosures rise, the GSEs start to lose money; after all, they either hold these mortgages in their own portfolios, or they guarantee the value of the mortgages that back privately held mortgage-backed securities. While delinquencies on mortgages backed by Fannie and Freddie have been rising fast, they are still well below what has been seen in the non-GSE backed part of the mortgage market, like sub-prime and Alt-A.
What is it important to consider from this point forward?
Losses directly hit retained earnings, which is the biggest part of equity. Thus as equity falls, leverage rises, and Fannie and Freddie are already too leveraged to start with. Either the equity has to be replaced, or assets have to fall -- simple 4th grade arithmetic. Well, with Freddie shares trading for about $9 a share, and Fannie's around $14, replacing the equity will be massively dilutive. Think pouring a shot of Dewar’s into Lake Michigan and calling it scotch and water. Existing shareholders would be effectively wiped out. On the other hand, if assets fall, that means that the GSE’s are not providing liquidity to the mortgage market, which will make the housing situation significantly worse.
The new housing bill had some provisions relating to the GSEs. What is the impact?
The recently passed housing bill allows the Treasury to invest an unlimited amount to prop up either or both or these firms. I think this is very troubling from a constitutional point of view. [Treasury Secretary Henry] Paulson argues that if he has a bazooka in his pocket and people know about it, then he will not have to whip it out (I will let you decide if there is any Freudian compensation issues with his analogy).
Hopefully this authority will not have to be used. If it is used, I would hope that it would be in the form of new equity. That would have the effect of reducing the leverage, as well as giving the government some upside in return for the extraordinary amount of risk the taxpayer is taking on here. Clearly the government cannot allow these institutions to fail, but there is a difference between the institutions and the interests of the existing shareholders and management. Let’s just hope that Secretary Paulson (or his replacement in the next administration) knows the difference.
Dirk van Dijk, CFA is the Director of Zacks Equity Research.
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This article has 2 comments:
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Danny L. Newton
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Jul 30 10:22 PM-
pcyhuang
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Jul 31 12:14 AMPaulson's push of covered bonds issued by the big banks could alleviate the stated problem above.