Tom A's Stock Picks

Fannie and Freddie - capital-lite financial strategies

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If I had to make one generalization as to why we have so much unease about our financial system, I would attribute it to the popularity of capital-lite strategies. Both banking and insurance are more profitable, but more risky, when done with reduced capital. The temptation is to push the envelope too far, rationalizing that risk has somehow been minimized and everything will be OK. Recent developments have highlighted the issue for Fannie Mae and Freddie Mac.

FNM and FRE are financial guarantors - they buy mortgages, hold some on the books, but bundle and sell most of them, guaranteeing the mortgages involved. If a mortgage that has been sold goes bad, they take it back. The situation is, they have been selling mortgages but retaining the risk of default. They recognize losses only when the mortgages are put back to them, which allows them to operate very efficiently - the capital-lite strategy. This is OK unless the merry-go-round stops, in which case they have losses to pay but no future income from which to pay them.

As GSEs, Freddie and Fannie enjoy the implied support of the Federal Government. With the mortgage securitization system in disarray, Fannie and Freddie have been annointed as the saviors and have increased their volume and market share, at profitable rates. OFHEO, their regulator, has relaxed already lenient capital requirements in order to permit them to perform their mission. Fannie and Freddie have enjoyed free access to capital markets, because of the implied Federal guarnantee, so the best case scenario is that they raise capital (debt, not equity) to cover their losses, continue to do new business at a profit, and everything works out fine. Shareholders are rewarded with ample profits form increasing volume and market share.

From a risk point of view, insurance companies and banks get most of their risk from three areas: operations, investments and liquidity. As a rule of thumb, an insurance company that does risky underwriting will do conservative investing, so as to mitigate overall risk. In the case of Freddie and Fannie, what they insure (conventional mortgages) is not very risky, and what they invest in (more of the same) is not very risky. As such, their overall risk profile is low, the exception being the use of inadequate capital creates a possible liquidity hazard. In my opinion, the Federal Government would intervene well befor liquidity would become an active issue.

Lehman Brotheres recently pointed out that technically the implementation of a new accounting standard, FAS 140, would require Fannie and Freddie to have much more capital than is now required. The shares tanked 20% on the news, but have rallied a bit since. CDS spreads (the premium to insure their debt against default) have widened substantially. Many observers have noted that the implied Federal support does not extend to shareholders, who would wind up with nothing if Freddie or Fannie had to raise dilutive capital due to excessive losses.

I watched an interview on Bloomberg TV with James Lockhart, head of OFHEO, on the subject. His position was, that as their regulator he saw no need for the additional capital and they were doing very well on the pay as you go scheme. All we need to do is just keep on rolling down the road: the only danger is if we stop. My reaction, based on politics as usual, is that the most likely outcome here is that Fannie and Freddie will be able to continue as they have been, potentially a lucrative investment - remember, both banking and insurance are profitable when done with a minimum of capital.

I looked at Freddie a few weeks ago, noting that their entire shareholders equity consisted of deferred tax assets. If management is unable to project sufficient future profits to use the deferred tax assets, they would need to be written off, reducing book value to zero. I shorted the stock briefly in my personal account, then covered as I couldn't get a handle on the political aspects of pretending everything is OK.

After my experience with financial guarantors ABK and MBI, I think that the popularity of negative bets on them is due to its effectiveness as a hedge against "the big one." In the event of a Depression, they are toast. That is why the short sellers are so fearless and the CDS spreads so wide. Now that line of thinking is starting to spread to Fannie and Freddie. If this is the big one, the stocks go to zero, and a short position is a wonderful hedge against an extreme outcome to our current economic difficulties. The thinking on the CDS has got to be the same - if this is the big one and some of the agency paper is no good, those who hold CDS protection on Freddie and Fannie will rule the world. An attractive prospect.

A likely outcome is that Freddie and Fannie will be shorted mercilessly, and coddled carefully by regulators, creating an extreme buy point for those who care to bet on the idea that this is not "the big one."