Fannie/Freddie credit is good again, but what about U.S. government's?


Fannie and Freddie
Likely to Plunge,
Searing Investors

By Tom Lauricella, Serena Ng, and Robin Sidel
The Wall Street Journal
Monday, September 8, 2008

The government's plan to take over Fannie Mae and Freddie Mac may help the housing market and boost the value of the firm's bonds, but it's a body blow to stockholders that include some of the country's best known mutual funds and biggest banks.

Under the plan, the government will own 80% of the two companies, leaving common stock holders with the remaining 20%, or one-fifth of what they owned on Friday.

Owners of the companies' $36 billion in preferred shares also fare badly. They've already seen the value of these once-safe securities fall by half, and some argue they are worthless now that the dividends have been halted and because they will absorb any losses before the U.S. government is hit with them.

The ultimate value of both securities depends on how well Fannie and Freddie perform and how the government rescue effort plays out over the next several years.

For stock investors, the takeover makes a bad situation worse. While they were once among the biggest companies in the stock market, Fannie and Freddie's shares were worth $7.5 billion and $3.3 billion respectively on Friday. Freddie's shares fell 92% in the past 12 months, while Fannie's are down 90%. For those who bet against the shares, it was a windfall and a vindication.

Fannie Mae closed Friday at $7.04 and Freddie at $5.10 and both fell sharply in after-hours trading as word that a takeover was imminent. They are expected to plummet when the market opens on Monday.

"Based on this announcement, one can reasonably conclude that things must be materially worse at Fannie and Freddie than what the companies and the government had acknowledged only several weeks ago," said William Ackman, of Pershing Square Capital Management, who has been short Fannie and Freddie stock since early this year.

When it comes to the holders of the bonds that Fannie and Freddie issued backed by home mortgages, the step makes those obligations "money good," says Pimco's Bill Gross. "The Treasury doesn't want to guarantee a trillion in assets ... but it's a big step. I think not only the Pimcos of the world but also the sovereign wealth funds and central banks will gain confidence that there is absolutely no possibility of default."

That means those bonds are likely to rally, narrowing the gap, or "spread," between yields on these securities and Treasury bonds. That, in turn, should help lower interest rates on new home loans, making them more affordable for borrowers. Fannie and Freddie were supposed to fulfill this role by purchasing more securities, but their capital positions had limited their ability to significantly expand their mortgage investment portfolios.

Andrew McCormick, head of securitized products at money manager T. Rowe Price, says Treasury's purchases coupled with agency buying of mortgage securities could help push spreads down by one percentage point. Over time, that could translate into a full percentage point drop in mortgage rates for home buyers. "This will put quite a jolt into the mortgage market," Mr. McCormick says, adding it is a step towards stabilizing the housing market.

The government's more explicit backing behind agency debt will also give other holders -- especially overseas investors like central banks -- more comfort that their investments are secure.

One big unknown is whether investors will grow more worried about the credit worthiness of the U.S. government given how much additional debt it has taken on. If that occurs, interest rates of Treasurys could rise, which could slow an economic recovery.

The carnage is widespread. The development is another blow to Legg Mason's Bill Miller, whose flagship Legg Mason Value Trust mutual fund is already down 31% this year. In early August Mr. Miller's group reported that it had raised its stake in Freddie Mac to 79 million shares from about 50 million earlier this year.

That move made investors in Legg's portfolio the largest shareholders of the company. In a shareholder letter Mr. Miller dismissed the sell-off of Fannie and Freddie as part of a "frenzy" that took financials to the recent lows in mid-July. Mr. Miller didn't respond to a request for comment.

A big miscalculation on the part of stock investors was to focus on whether the two agencies were technically insolvent and on their business prospects but miss the risks that a weakened Fannie and Freddie posed to the already battered U.S. housing market.

Investment firm Dodge & Cox, for example, justified its investment by saying business was improving for Fannie and Freddie. The firm, which owns roughly 119 million shares of Fannie Mae bought the bulk of its stake in the company during the first quarter when the stock was trading between $18 and $40 per share.

In a letter to fund shareholders, Dodge & Cox cited Fannie Mae as an example of a company that "appeared to profitably increase their market share" during the first quarter.

"We are currently studying the implications of the unprecedented action ... and are reviewing our options," a Dodge spokesman said Sunday.

Pzena Investment Management, which owned 21 million shares of Fannie Mae and at one point counted the stock as among its funds' biggest holdings, defended the two agencies in July in a public three-page letter titled "The Case for Fannie and Freddie" in which the company's managers wrote that both had sufficient reserves and capital and "significant revenue generation capability." They argued that "what's really needed is to resist the temptation to try and fix something that is not broken." The firm would not comment.

It is unclear what will happen to Fannie and Freddie's publicly traded stock. Top officials of the New York Stock Exchange have been in discussions with government officials and other parties about the two companies' listing status, according to a person familiar with the matter.

If the shares fall below $1, NYSE may be forced to impose a so-called operational trading halt, which means Fannie and Freddie shares would stop trading on the exchange floor and move to electronic platforms such as NYSE Arca. In the longer-run, the companies could be delisted from the Big Board if they no longer meet NYSE listing criteria.

Also feeling pain from the buyout will be many of the nation's banks, which own preferred shares in the government-sponsored entities that were once worth billions of dollars. In recent weeks, a slew of banks have disclosed their holdings to investors and, in some cases, written off the value due to the steep declines in Fannie and Freddie's stock prices.

That means more bad news for the banking industry, which is already reeling from rising defaults in everything from mortgages to credit cards, as well as poor returns on other mortgage-related investments. The government takeover plan appeared to take this into account, saying only a "limited number of smaller institutions" have holdings of common and preferred shares that are significant as compared to their capital.

But the bigger impact on banks might be their ability to attract new investors. "Preferred shares have been a primary tool for banks and dealers to raise capital, and these developments could impound the asset class" and make it harder for others to sell similar securities, says John Miller, chief investment officer of Nuveen Asset Management, which has a preferred stock fund.

The Treasury sought to assuage concerns Sunday, saying that preferred stock of Fannie and Freddie is "not a good proxy for financial institution preferred stock more broadly."

J.P. Morgan Chase & Co. is among the banks that will likely suffer losses due to its exposure. The big bank recently disclosed in a regulatory filing that its $1.2 billion investment in preferred shares of Fannie and Freddie had lost about $600 million in value.

A J.P. Morgan spokesman declined to comment on the government takeover of the two entities.

In a report issued last month, debt-research firm CreditSights cited M&T Bank Corp. and Sovereign Bancorp Inc. as being among the most exposed to Fannie and Freddie preferred stock. The CreditSights report estimates that a total write-off of Sovereign's holdings in Fannie and Freddie could wipe out as much as four quarters worth of earnings.

In response to that report, Sovereign said that it took into account potential declines in its investments when it raised capital earlier this year.

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