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Sep.08

9:15 AM ET

Monday, 8 Sep 2008

Fannie, Freddie: The Good And Bad Of Takeover

Posted By:Bob Pisani

Topics:Henry Paulson | Investment Strategy | Stock Market

While Fannie and Freddie are not trading pre-open (prevented by NYSE), the government rescue of Fannie and Freddie is having a very notable effect on financial and homebuilding stocks. Financials which hold significant amounts of Fannie and Freddie debt are also up, including AIG, up 11 percent. Money center banks like Citigroup [C Loading... () ]and Bank of America [BAC Loading... () ]are also up in the high single digits.

Builders like Beazer[BZH Loading... () ], DR Horton[DHI Loading... () ], Pulte[PHM Loading... () ] are up double digits pre-open.

One question is how much, if any, losses might be incurred from the many small and medium sized banks that own Fannie and Freddie preferred securities. While not worthless, the dividends are suspended and they will certainly trade down.

Terms of the agreement include a:

1) Stock purchase agreement. There will be a cash infusion now, with the government receiving $1 billion of senior preferred stock with a 10 percent coupon, and warrants representing 79.9 percent of the respective companies.

2) MBS purchase program. Treasury will also be purchasing agency mortgage-backed securities (MBS) in the open market.

3) Credit facility. A GSE Credit Facility will provide secured funding on an as-needed basis to Fannie and Freddie.

One of the main goals is to reduce the size of both organizations. In 15 months, each company must reduce their retained portfolios (the mortgages they actually hold) by 10 percent, until they hit $250 billion. That's a long way off: right now Fannie Mae has $737 billion in its retained portfolio, Freddie has $792 billion.

After that, they will still have the guarantee business, but they will be much smaller entities.

What happens after that? No one knows, not even Mr. Paulson. Their long-term fate is in the hands of the next President and Congress. They could split them up and sell them, as Mr. Greenspan has argued, or they could fully nationalize them.

What about the stock of Fannie and Freddie? The dividends for both common and preferred have been suspended. Stockholders will still be kept alive, but as Mike O'Rourke noted, they will be "in a long-dated coma." Officially, the powers of the stockholders are suspended until the conservatorship is terminated, though the stockholders will retain all rights in the stock's financial worth, whatever that is.

The good news:

1) lower mortgage rates. This should notably tighten spreads between Treasury bonds and mortgage backed securities. How much lower? I noted three weeks ago that the spread between 30 year fixed rate mortgages and Treasury yields was about 270 basis points; historically it is about 170 basis points. So theoretically, mortgage rates could fall by 100 basis points, though that is unlikely. But even a half-point cut would bring rates down to about 6 percent.

This morning, the 30-year FNMA mortgage rate current coupon is down 17 basis points to 5.456%, the lowest since late May.

2) boosts confidence in financials markets.

The bad news:

1) this will not solve the housing crises. This does not address the increase in delinquencies and other issues, but even cynics would note it is an important component in addressing the crisis. FHFA Director James Lockhart said on our air that "we may be in the start of a bottoming phase" and these actions should help.

2) it may not solve the stock market's problem. A global slowdown will not be reversed by these actions.

Cynics, who have grown accustomed to selling rallies, expect to see the highs of the day early; but bulls are arguing that this is the second leg of the bottom that began in July.

The Street is abuzz about the large amounts of cash on the sidelines, but to lure that in we will need higher volume and a consistent uptrend to lure in all those sitting on that cash. Bulls argue that this is a very important step to restore confidence and start luring those people in.

Elsewhere:

1) Washington Mutual [WM Loading... () ]ousted its CEO, Kerry Killinger, and entered an agreement with its regulator, the Office of Thrift Supervision, that effectively puts it on probation. Washington Mutual is essentially now reporting to OTS, provided them with updates on its business plans. Stock is trading up, partly on the statement that it will not be required to raise capital.

2) two stories on Lehman[LEH Loading... () ]:

a) Times of London reports Lehman is exploring splitting itself into 2 companies - creating a "good bank" and a "bad bank." The new "bad bank" company would hold $32 billion in commercial mortgages. An announcement could come at the end of the month when the company reports its Q3 results.

b) Merrill Lynch upgrades Lehman to neutral from underperform. It believes the FNM/FRE bailout will help LEH to "attract the equity capital it needs at a price around the current market" ("despite the likelihood of another big loss as the company seeks to sell illiquid real estate-related assets").