Tom A's Stock Picks

Fixing Fannie and Freddie

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Citing persons familiar with the matter, the WSJ says Paulson is near to determining the fate of FNM and FRE - an announcement could come as early as this weekend. Bill Gross has chimed in with his recommendations. Bill Ackman has been heard from too. The universal conclusion is that the ends of justice will be served by wiping out the common shareholders and maybe even the preferred shareholders should take a big haircut. But Bill Gross should be covered OK on the bonds, says Bill. I don't know what Ackman says, but I imagine it favors some sort of short position or something he did with credit default swaps or puts. Good old BIll. Anyway, here is my opninion:

I am not a shareholder, but I have trouble with the idea that the government should wipe out their interests. Fannie and Freddie were supposedly private businesses with a public interest duty to support affordable housing. The government set capital requirements for the business, and both companies are in compliance. So to me the idea that the government should exert some sort of financial eminant domain and dispossess shareholders seems unfair.

In point of fact there is no immediate danger of insolvency, both FNM and FRE can go on idefinitely as long as they can turn over their debt. Much of the crisis has been created by a carefully orchestrated series of attacks, with the article in Barron's providing what very nearly proved to be the coup de grace. Never hesitant to invoke conspiracy theory, I see a scheme by the far right to discredit FNM as a relic of the New Deal. By their reasoning, we could use a man like Herbert Hoover again.

I advocate a rights offering backed by the US Government. Existing shareholders would recieve rights to buy shares at below market value, sufficent to raise the required capital. The rights trade on the open market and the shareholders could sell them if they didn't want to exercise. Any rights that are not exercised would revert to the Federal Government, which would then be an owner to the extent existing shareholders and other market participants passed on the deal. That would achieve fairness for shareholders by allowing them to dilute themselves if they have the courage. In Freddies's case the amount to raise would be the 5.5 billion they told their regulator they would raise. FNM could aslo do a raise in due course.

Eventually the panic will subside and the Government will be able to sell any shares they might own at a profit. FRE and FNM have a virtual monopoly and with interest rates so low they have a good margin on new business, so they would become profitabe as housing recovers. The usual short memories would set in and the stocks would go back up to where they came down from.

Bear in mind that a lot of the shares are held by institutions, many of whom are long term believers in the stock and will be glad to salvage their investments.

Finally, the enabling legislation reads as follows:

"(A) GENERAL AUTHORITY -- In addition to the authority under subsection (c) of this section, the Secretary of the Treasury is authorized to purchase any obligations and other securities issued by the corporation under any section of this Act, on such terms and conditions as the Secretary may determine and in such amounts as the Secretary may determine. Nothing in this subsection requires the corporation to issue obligations or securities to the Secretary without mutual agreement between the Secretary and the corporation. Nothing in this subsection permits or authorizes the Secretary, without the agreement of the corporation, to engage in open market purchases of the common securities of the corporation.

"(B) EMERGENCY DETERMINATION REQUIRED -- In connection with any use of this authority, the Secretary must determine that such actions are necessary to --

"(i) provide stability to the financial markets;

"(ii) prevent disruptions in the availability of mortgage finance; and

"(iii) protect the taxpayer.

"(C) CONSIDERATIONS -- To protect the taxpayers, the Secretary of the Treasury shall take into consideration the following in connection with exercising the authority contained in this paragraph:

"(i) The need for preferences or priorities regarding payments to the Government.

"(ii) Limits on maturity or disposition of obligations or securities to be purchased.

"(iii) The corporation's plan for the orderly resumption of private market funding or capital market access.

"(iv) The probability of the corporation fulfilling the terms of any such obligation or other security, including repayment.

"(v) The need to maintain the corporation's status as a private shareholder-owned company.

"(vi) Restrictions on the use of corporation resources, including limitations on the payment of dividends and executive compensation and any such other terms and conditions as appropriate for those purposes."

Where I would hang my hat is "the need to maintain the corporation's status as a private shareholder-owned company." That does seem to limit Paulson's options. The phrase "obligations or securites" seems broad enough to include a rights offering. Finally, note the use of the terms "mutual agreement" and "agreement." Paulson does not have unilateral authority to make a determination as to where in the capital structure he comes in: he needs to secure a mutual agreement.