You've Got Five More Years To Trade Fannie And Freddie Preferred Stock

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Over on the imaginary stock markets where Fannie Mae and Freddie Mac trade they've had a rough day, with FNMA and FMCC common stock each down almost 13% and the preferred ... um ... down surprisingly small amounts but, y'know, on light volume. The impetus is presumably this:

A bipartisan group of senators on Tuesday introduced a bill to abolish Fannie Mae and Freddie Mac and replace them with a government reinsurer of mortgage securities that would backstop private capital in a crisis. ... Under the bill, which is being led by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner, the two companies would be liquidated within five years.

Here you can read the announcement, summary, and text of the bill, and I suppose we should discuss it at some point. The basic idea is that a new government-backed mortgage insurer would insure the credit risk of conforming mortgages, so long as private capital bore the risk of at least the first 10% loss,1 making it sort of a medium-sized step from "government insures basically all credit risk of mortgages" to "the mortgage market is on its own." Which seems reasonable though fault is already being found.

But what does it mean for the poor beleaguered Fannie and Freddie common and preferred shareholders? Umm, nothing good. The text of the bill says "any proceeds from the wind down of an enterprise [Fannie/Freddie] shall be paid first to the senior preferred shareholders of each such enterprise, then to the preferred shareholders of each such enterprise, and then to the common shareholders of each such enterprise." The government is the senior preferred holder, with $188 billion, so you could imagine a liquidation that brings in more than that recovering some value for the junior preferred and common? But, naaah, elsewhere they make it fairly clear that the existing profit-sweeping - where essentially all of the GSE's profits go to Treasury too - will remain in effect, so that "then to the preferred ..." is just a tease. They're hosed.

Maybe. When we first talked about the Fannie/Freddie preferred stock trade, a bunch of people used words like "unimaginably long odds" to describe the chances of those preferred holders ever getting any money back. On the other hand! Reuters today quotes a Guggenheim Securities policy analyst saying "that there 'is almost zero chance the bill introduced today will be adopted' as it is currently written." So right now we remain in a pleasant limbo where there's no chance of Fannie and Freddie shareholders getting any money back, but also no chance of them not getting any money back.2

The devil is in the usual place, and winding up Fannie and Freddie is pretty complicated. Like: it's hard to get rid of them in 5 years when they issue 30-year mortgage guarantees. What do you do about that? Well, even after you explode Fannie and Freddie, you leave their guarantees outstanding.3 And since the guarantees of a nonexistent entity aren't worth much you need someone to step into them. And who else but:

The full faith and credit of the United States is pledged to the payment of all amounts which may be required to be paid under any obligation described under subsections (a) and (b) [i.e. ghost-Fannie/Freddie obligations].

So all of Fannie and Freddie's debt would become U.S. debt. Runoff would reduce it, but these days that's $3.25trn at Fannie and $2trn at Freddie. Remember the fight over the last increase in the Federal debt ceiling, of around half a trillion dollars? That might give Fannie and Freddie shareholders some comfort that adding five trillion dollars to the U.S. debt will take a while.

Senators push bill to scrap mortgage firms Fannie, Freddie [Reuters]
Banking Committee Senators Introduce Legislation to Modernize and Reform America's Broken Housing Finance System [Senate]
Housing Finance Reform and Taxpayer Protection Act - Summary [Senate]
Draft Corker-Warner Bill [Senate]

1.Technically it requires:

the first loss position of private market holders of a covered security insured under this Act—
(1) is adequate to cover losses that might be incurred as a result of adverse economic conditions, wherein such conditions are generally consistent with the economic conditions, including national home price declines, observed in the United States during moderate to severe recessions experienced during the last 100 years; and
(2) is not less than 10 percent of the principal or face value of the covered security.

Questions include:

  • What is the value of a guarantee that only covers conditions worse than moderate to severe recessions over the last 100 years?
  • Wait, moderate, or severe, or what?
  • How does 10% match up against that? Consider that the summary says "Ten percent is more than double the total loss severity experienced by Fannie and Freddie between 2007 and today" though, like, tell that to Florida or whatever.

2.Also there is the lawsuit where Fannie and Freddie shareholders are arguing that the nationalization of their enterprises was an unconstitutional taking of property by the government without compensation. Ponder whether this bill would provide ammunition for that lawsuit. (Or, technically, for another lawsuit. Like Bruce Berkowitz could sue over Congress taking away his weird limbo preferred.)

3.Section 501(a) of the draft bill (501(b) is the same but for Freddie):

Effective on the FMIC certification date, the charter of the Federal National Mortgage Association is repealed and the Federal National Mortgage Association shall have no authority to conduct new business under such charter, except that the provisions of such charter in effect immediately before such repeal shall continue to apply with respect to the rights and obligations of any holders of—
(1) outstanding debt obligations of the Federal National Mortgage Association, including any—
(A) bonds, debentures, notes, or other similar instruments;
(B) capital lease obligations; or
(C) obligations in respect of letters of credit, bankers’ acceptances, or other similar instruments; or
(2) mortgage-backed securities guaranteed by the Federal National Mortgage Association.