Our view on Freddie and Fannie

As everyone is aware, the Fixed Income markets have been very volatile as panic selling jumps from one corner to another. The most recent episode has ensnared Fannie Mae (FNM) and Freddie Mac (FRE). Fannie and Freddie have seen their common stock plunge over the past week. News outlets all over the place, including the front pages of NYT and WSJ, have been saying that these companies are in major trouble. We do not hold any common stock of FNM or FRE. This does affect our fixed income holdings, mainly our preferred stock holdings of FRE and FNM. This has affected our performance this year and will continue to have a negative impact until the market normalizes. However, I do believe that these are good investments in the long run and that we should continue to hold our positions.

We own several distinct types of bonds issued by Fannie and Freddie. First, and the largest of our holdings, are FNM and FRE backed mortgage backed securities. These bonds are collateralized by the underlying mortgages. As long as the homeowner makes their payment, we receive our payment regardless of the condition of FRE and FNM. If a mortgage goes delinquent or defaults, then FNM and FRE take the loss and pay the bondholder all principal and interest. On these bonds, FNM and FRE are basically acting as insurance. The second type of bond is a Senior Debenture. These are essentially corporate bonds issued by FNM and FRE. They are rated AAA by all the ratings agencies even though they are unsecured senior debt. These are the bonds that FNM and FRE use to fund their operations. It would be unfathomable if FNM or FRE ever defaulted on either of these types of securities. The repercussions on the global markets would be huge.

The last kind of debt that we own is the preferred stock. Even though it is called stock, this is debt of the company that the company can count as capital. FNM and FRE preferred stock is rated AA because in the event of liquidation, it is subordinated to all of the senior issues and MBS guarantees. There is less confidence in the market right now that the preferred stock would be bailed out along with the senior debt. This has caused the preferred stock to slide 25%. However, I am still confident that we will receive our principal and interest payments and that the market price will normalize over time. This current sell-off appears to me to be panic selling and unjustified.

Background—

Fannie and Freddie are government sponsored enterprises. They were created through and act of Congress in order to provide liquidity to the mortgage market and foster home ownership. They were then sold off to private investors and are now publically traded, private enterprises. However, they have their own government regulator, OFHEO, that closely supervises all of their actions and determines adequate levels of capitalization. FNM and FRE also have a line of credit directly with the US Treasury. In the event of a liquidity crunch, these two companies have direct access to the Treasury to meet obligations. This is something that no other company has.

The recent turmoil was sparked early this week when a research report by a Lehman Brothers analyst stated that FNM and FRE may have to raise over $65 billion in capital if a new accounting standard was adopted. This new accounting standard relates to how companies account for mortgage servicing and is still in very preliminary stages. These standards are often radically altered prior to being (if ever) adopted. At the end of the research report, the analyst stated that even if the guideline is adopted as is, FNM and FRE would be exempted. The entire report was a big hypothetical exercise and even the author does not see much chance of it ever coming to reality. However, this was enough to send the stocks in a tailspin that has lasted all week long as every bit of negative information and every doom and gloom scenario has been played out in the press. However, there has been no new material information released about the companies. All that is “news” is rehashed arguments and figures from their last earnings report. Here are a few facts to focus on:

The Bad

• FRE and FNM do need to raise more capital and this is a difficult market to raise capital.
  Foreclosures will remain elevated for at least the next year. This will put pressure on


• FNM and FRE earnings and capital for some time.


• Market is losing confidence in the companies. This is seen in the violent movement of the stock.

The Good

• OFHEO continues to say that FNM and FRE are adequately capitalized.


• FNM and FRE have a history of underwriting higher quality loans. Their foreclosure rate is ~1%. They do have exposure to lesser quality mortgages, but only ~5% of assets.


• Congress is looking to FNM and FRE to help stimulate the housing market. Makes government intervention more likely if needed.


• Have a line of credit with the Treasury.


• While borrowing at highest spreads since 2000, they are still able to issue senior debt at more attractive levels than other US Corporations. This is their primary source of funding.
  

It is my opinion that long term these will be sound investments. I think that they market will regain confidence in the companies, they will raise more capital, and things will normalize. I still believe that we will receive our scheduled principal and interest payments on the preferred stock that we own.

Ryan Craft, CFA