Constructive uncertainty redux

Warning – this post is designed to annoy market fundamentalists and the naked short selling crowd…

The main argument against nationalising failing financial institutions at this point comes down to moral hazard.

This is a short post with the idea of turning that on its head.

Debt markets are currently illiquid and highly skittish.

It is alleged that short-sellers are causing problems – but if they are causing problems its not in the equity markets – its in the debt markets. Relatively small amounts of selling of debt can cause a very wide – and possibly self-fulfilling rise in the spread of some financial institutions.

And if financial institutions are going to be allowed to fail you can short their debt with impunity. Drive the credit spread up. The confidence collapse will make you a killing - at least according to Vanity Fair.

But thanks to Paulson et al you can’t do that any more.

AIG proves the government might make the bonds you shorted whole. Anyone shorting AIG debt just had their ass handed to them.

So if you short debt now – what you face is constructive uncertainty.

It might give the smarties some room for pause.

John Hempton

Bailouts - past and present

I can just see the argument. Congress is upset that good American taxpayer money is going to rebuild Germany.

The conservative press argue about Moral Hazard. If countries elect dictators and then try to take the world over by force and exterminate minority races there is no loss to them if you rebuild. We shouldn’t rebuild them – better leave them a smouldering ruin and lay waste Europe because otherwise we would have moral hazard.

And so the Marshall Plan died.

Fortunately it didn’t happen that way. Europe was rebuilt and the world wound up a safer place.

And so I make a plea to the world. Please dump this bailouts are a bad idea thing.

Some bailouts turn out to have been a very good idea – some are suspect. The bailout of Mexico didn’t wind up costing the taxpayer very much – and was better than the alternative – a complete social debacle on a country that last I looked shared a long border with the United States.

The Norwegian bank bail-out of 1992 cost the shareholders a pretty-penny (they lost everything). But the Norwegian economy bounced quite rapidly and the Government actually made a profit.

By contrast the first bailout of S&Ls in the early 80s set up a much larger debacle in the late 1980s (see my history of US Finance paper).

What is really required is not a blanket rule against bailouts – or a blanket rule for them – but – what is in my favourite phrase of the day “constructive ambiguity”. Oh, and sacking the management of said institution for cause and denying all the golden handshakes etc. Suing Dick Fuld would be a start too.

John Hempton

Private Equity is like so yesterday

In early 2007 if the deal was there several large private equity firms could have teamed up and found 75 billion dollars.

No problems except that they couldn’t find the deal to do.

The deal is there today. AIG, 75 billion down at 10%, 60% equity stake out the back.

Alternatively buy the whole shebang for another 4 billion and be done with it.

The deal makes sense. Certainly a whole lot more sense than paying 30% over 2006 stock market values for most large private equity deals.

But the AIG can’t be done because private equity is a shadow of its former self.

That I guess is a measure of how long the certainties of Wall Street last. A week is a long time in the markets. 18 months is like - forever...

John Hempton

Where is a trillionaire when you need them: too big to bail out

AIG has good businesses and bad businesses. Nobody much thinks that the life insurance businesses are problematic. I don’t like life insurance for reasons made clear in the Risk Aversion post – but if you are going to own a life insurance business these are about as good as it gets.

The core business – the US Domestic Broker Group (DBG) is the best diversified primary insurance company in the US. That doesn’t make it a good business but it is OK. [Insurance businesses are the ultimate payers of US legal settlements – and I wouldn’t really want that much litigation risk…]

There are other OK businesses in there.

The good businesses generate about 20 billion per year pre-tax. That is a lot of dosh.

There are some staggeringly bad businesses in there too. AIG Financial Products probably has blown up something between 30 and 100 billion. Ultimately we have no idea what the AIGFP losses are – but we do have some idea of the huge margin requirements.

The management has been profoundly stupid. In the last annual report the letter tells us how now is a great time to expand in mortgage insurance in Australia. Australia is the greatest remaining bubble in residential real estate.

I knew in March 2007 that AIG was up to its neck in super-senior exposure. That is what bought the company down - and in March 2008 AIG management still had little idea that it was in mortal danger.

Moreover past management lied about profitability. That is what the whole finite insurance thing with Berkshire was about - and it will lead to jail terms for several executives. Companies with a record for lying tend to find it hard to get money because nobody trusts them in a pinch...

But here is the rub.

There is no suggestion that the core insurance companies of AIG are impaired. AIG parent company however needs a huge amount of money – say 70 billion dollars - and it needs this largely to meet funding requirements driven by AIGFP. 70 billion is a number that petrifies everyone who looks at it.

But 70 billion is actually not that much compared to the core insurance companies. They should be easily able to repay that. Its only 3.5 years’ profits and should be repayable in 8-10 years provided there are no plagues or other nasty insurance stories.

So now suppose that you were a wise independent multi-trillionaire. Would you lend 70 billion to AIG at 10% secured by whatever you could and with an attached option to buy 60% of AIG at a notional price?

I think you would. It wouldn’t be a bad deal. (You would not do it if you accepted AIG's open ended fat-tail liabilities.)

But unfortunately I can’t see any trillionaires out there. Warren Buffett won’t do it because frankly he is not quite that rich and he will not amalgamate the life insurance companies into Berkshire. Buffett has one-giant shot in his armoury - and this one is not it.

And therein is the problem with AIG. There are no multi-trillionaires and AIG is too big to bail out.

John

PS. I don’t want to do politics on this blog. But I suspect its time for the Fed to lubricate a multi-bank bail out. The deal is as suggested here. 70 billion at 10% for with 60% of the equity.

I am not sure how the Fed lubricates it other than say putting an envelope around the losses of AIGFP.

As for the stock - I am sitting on the sidelines.

J

Am I meant to say something smart here?

I can not.

I figured almost everyone was in trouble - but in my wildest dreams it never went in this order:

New Century,
Dozens of other subprimes but without Novastar actually filing bankruptcy
Bear Stearns
Indy Mac
Fannie and Freddie
Lehman
AIG

I have shorted most the stocks on this list - but managed not to pick the order of insolvency and have been short none of them recently. AIG was not a conceiveable bankruptcy in my mind. Sure I knew about the fake accounting with finite insurance and the mortgage insurer. I even knew they owned $20 billion in "super-senior" so they were clearly stupid. But I never knew enough. The stock was always too expensive - and as I found out more it stayed too expensive...

There are plenty of people speculating as to what all this means. I will leave that to them. I want to stick to stuff I do understand. There is still a little of that around...


J

Weekend edition: Merrill Lynch and a guy who admits killing an underworld hitman

All my favourite blogs are in a rut this weekend. The finance blogs are all Lehman all the time. The political ones are all Sarah Palin all the time. Both are serious issues but on which I can add little original thought.

I have actually bothered to read a Lehman 10K cover to cover once. I understood only marginally more when I finished than when I started - so my ability to add value is thin. [Then again almost nobody actually understands the brokers.]

Given my lack of ability to add to the real issues I thought I would do something different – something highly tangential but topical – only because it involves a failing broker and this is the weekend of failing brokers. It also gives me a wonderfully salacious title. The title is only deserved because Merrill Lynch lent to a dodgy organisation which in turn lent to the underworld. It failed to do due diligence and it may have failed to perfect security.

Failing Australian brokers

When brokers fail there are losses for people who have financed the broker with bonds etc – and these losses are generally not transmitted systematically. And then there are losses to counterparties who are just trading with the broker in the ordinary course of running their investments or running their businesses. Those losses are much more systematically dangerous because they make people scared to deal with all brokers and potentially with counterparties to brokers and hence can cause systemic problems.

Australia recently had some very large problems at very small brokers. These brokers are much smaller than Wall Street behemoths – so whilst they might provide some dry-run tests of the problem – they are just worth reading about because they are so colourful.

First however I am going to start with a diversion – the Melbourne gangland wars

The Melbourne Gangland wars

Melbourne – the second largest city in Australia - recently had the colourful spectator sport of pretty well the entire crime establishment murdering each other in a tit-for-tat professional hit style.

Given that (almost) all the victims were underworld characters when the murder trials happened at the end it was hard to get people to take them seriously. As far as most Melbournians were concerned if the underworld wants to remove each other why should anyone want to stop it?

One of the more interesting characters from the gangland wars was Mick Gatto – a former heavyweight boxer who was named as enforcer at various legal inquiries. He has convictions for burglary, assaulting police, racketeering, possessing firearms, and obtaining financial advantage by deception. Most Wall Street brokers wouldn't want him to marry their daughter.

Mick Gatto shot Andrew Veniamin who was an underworld hitman. He was arrested and the prosecutors over-reached charging him with first degree. Gatto convinced the jury that if he hadn’t shot Veniamin, then Veniamin would have shot him. It was self defence he cried and the jury agreed. Given that everyone even remotely involved seemed to get murdered the jury was probably right.

Mick Gatto’s private business has a title that if it were a Government department you would consider Orwellian. It is Arbitrations and Mediations Pty Ltd.

Mick Gatto would be fearsome when arbitrating any dispute

Opes Prime

Now having got this far I thought I should introduce the stockbroker. The broker was called Opes Prime. Opes did a really neat trick of allowing a little more leverage than most stock brokers, accepting small caps as collateral and allowing a very much wider range of shorting than most stock brokers.

Opes used documentation loosely based on US Prime Brokerage documentation to deal with its clients. In Australia most brokers hold their clients shares in a custody arrangement called CHESS in the clients names. The shares cannot be repledged. Some margin lenders (notably Leveraged Equities) provide securitised margin loans where the repledging of the shares looks legally difficult. Opes however provided loans provided you pledged your shares to them and granted them permission to repledge those shares. Read that twice – it is startling – but it is in fact not different from a lot of margin accounts provided by brokers globally.

When Opes went bust the clients discovered that they did not own the shares. Opes didn’t own them either because they had been repledged to ANZ Bank (an large Australian bank) and a firm most readers of this blog will be familiar with – Merrill Lynch.

Merrill Lynch and ANZ took the collateral that was pledged to them and sold it to recover most their loans (it may have been all their loans in the case of Merrills). Opes had over a billion dollars in debt to these institutions, 500 million of which was to Merrills.

There were people with $1 million in stock at Opes and with loans of $100 thousand and they lost everything.

Opes was an ugly story – it hardly reflects well on Merrill or ANZ. Both ANZ and Merrills are being sued for aiding and abetting a fraud. It really matters who you lend a half a billion to these days...

It is also potentially going to get VERY ugly for Merrill Lynch. There is quite a deal of evidence that neither ANZ or Merrill Lynch properly perfected security over collateral that they sold in satisfaction of their loans to Opes Prime. They are getting sued by the liquidator with the aim or removing their status as secured creditors. If Merrills loses this they probably lose a quarter of a billion. ANZ looks to want to settle so there is a real case here.

Tying the two parts of this post together

I started with the Melbourne underworld and their grotesque series of murders – and I wound up with Merrill Lynch and ANZ. I need a pretty good segway here.

So here goes. It turns out that one of the big client group of Opes were – as the press phrased it

business people if you very loosely used the term ‘business people’.

What were they doing? I don’t know – what do such business peopled do in a market with a broker that will allow them to short anything and doesn't ask too many questions about insider trading? You can fill your own details in.

And where did the OPES money go? After all they didn’t piss it against the wall with mindless speculation as per Lehman. They lent it on margin – but most margin loans should be collectable by selling stock (so a broker needs to be pretty incompetent to lose it).

But they did lose it – hundreds of millions of dollars worth of it.

Somehow the rumour is that it went to Singapore (and then presumably on into the financial netherworld). And then Mick Gatto – remember him – the guy that killed Andrew Veniamin got on the plane (first class I gather) and flew to Singapore to chase it. He was doing it on behalf of the above mentioned "business people" who were now clients of Mediations and Arbitrations – a firm that promises to "make problems disappear".

Here is a picture of Mick on the chairs in the Singapore Airlines lounge in Singapore. I have sat on those chairs myself.

And here is the press link to explain his visit.

I have no idea who he was chasing but what we know is that Merrill Lynch (possibly without perfecting their security) funded a dodgy stockbroker who in turn funded rather suspect people in Australia, and then lost their money and somewhat annoyed a real life Dexter – a guy who admitted killing an underworld hitman.

David Einhorn went after Lehman Brothers and won. But in the scheme of things David Einhorn is a wimp. At least Mick Gatto wasn't after them. Lehman never annoyed Mick Gatto and Merrill probably did.

=============

Now this is a serious investment blog - and I should answer the question on everyone's lips: "was there contagion?" The answer was YES. The other brokers with similar financing structures in Australia got into terrible trouble. Chimera hit the wall. Tricom is in diabolical trouble. The spectacular flame out of even a small broker causes contagion.

And that should worry everyone this week.

John Hempton

Funny – it is working!

At the end of an atrocious day I am going to be contrarian.

The Frannie bailout is working.

No – it can’t save Lehman.

And companies that have to roll over billions of dollars of debt in the next few years are all problematic.

But then there was no reason why injection of money into Frannie should have solved Lehman’s problems. Lehman has to find its own money or fail or be bailed out (at effectively total loss to shareholders).

All a Frannie bailout could do is make conventional mortgages – the stuff that Frannie issued and insured – cheaper. Any other claim for the Frannie bailout is a stretch.

And on the limited thing that it is doing the evidence so far looks good. Here is the yield of Fannie Mae perfect coupons – note the spectacular drop in the last few days.

Note the 5.16% current yield versus the approximately 6% this measure seemd stuck at before the legislation and the 5.7ish numbers before the weekend.

The 1.7 billion Pimco one-day gain is the same story.

Frannie Mortgages have got much cheaper in a few days.

That should flow through to retail mortgage rates far more effectively than any of the recent Fed cuts. It probably won't solve the housing problems but it will ameliorate them. Any other a-priori claim for the bailout was optimism over analysis. And you can claim the bailout is a failure by setting up and demolishing a straw man. But an objective look says this bailout is by-and-large succeeding at its modest aims.

John Hempton

Mortgage insurers and the bailout

One investor I respect was terribly surprised that the mortgage insurers fell on the Frannie bailout.

In my “Do you believe in magic post” I suggested that the mortgage insurers continue to write business only because of the continued goodwill of the GSEs. And the GSEs only do that because they hope the premiums on new business will allow the mortgage insurers to run ahead of the losses on the old business.

There has been a change of control of the GSEs. And the new management have no incentive to hide the losses of the old management by feeding premium to potential insolvent mortgage insurers.

I have no idea what the conservators will do to the mortgage insurers. But the change in management of the GSEs is unlikely to be positive though it may be neutral.

John Hempton

This blog’s evolving view on Fannie Mae

I was once short Fannie Mae understanding (well before their regulator) of the extent of the scam in their derivative accounting. I even managed to quantify it. [Funnily enough executives who I thought up to their neck in that scam are still in senior positions at Fannie. Will the conservator please sack them for cause. If they leave with big packages I will be disappointed.]

The stock however didn’t fall out of bed – and whilst we made money – it was hardly worth the stress.

When I first looked at Fannie for this blog my predisposition was to go long. However I would not do that without analysis – so I had a go at doing the analysis.

The first post – Fannie Mae Part I – detailed the revenue and pre-provision profit potential of the company. That was really the “upside case” and it was considerable. I got quite a lot of emails from short sellers who thought I was insane. They were right I might add.

Fannie Mae Part IA detailed my views about the way Fannie was feeding business to insolvent mortgage insurers to keep them solvent. It was bearish because the mortgage insurers provide protection for Fannie on a large number of high loan-to-valuation mortgages and if the mortgage insurers were rubbery then Fannie also was.

The next post was a plea to help model Fannie Mae’s losses. The range of numbers in the marketplace was huge – and the analysis behind those numbers was thin. It was however thin for a reason as the modelling post makes clear. My plea for help fell on deaf ears. This blog has 1000 daily visits but nobody could provide me a decent model of Fannie’s losses.

Fannie Mae Part II discussed whether Fannie Mae was insolvent or profoundly insolvent. I thought that mattered then and it matters now. If Fannie Mae is correctly reserved now I figure the stock is worth more than $8 even after the bail out. It is however not correctly reserved – and the extent of shortfall is the critical factor for the value of Fannie Mae and for the risk to Federal Government from this bailout. I figured if the shortfall were 80 billion then Fannie Mae was “borderline profoundly insolvent”.

Fannie Mae Part III gave up altogether and produced what I think remains a rubbery estimate of Fannie Mae losses above trend. The number was $64 billion – but there is some Alt-A and I should include trend losses. If you do that you get something close to $80 billion. I concluded – much to my surprise as follows:

My a-priori expectation was that Fannie was going to be better than that. If you had put a gun at my head and asked me would I prefer be long or short I would have said long.

Now I would say short.

I have no position and it is likely to stay that way. But for once I do not think the shorts are grotesquely overstating their case.

That call was good – but not strong enough. I should have shorted the stock.

After the fix was in and the legislation was in place to guarantee Fannie Mae I was perplexed that Fannie Mae spreads did not drop. In this post I made one of the best observations I have made on this blog – but I did not hammer it home because I thought the spreads were so irrational they would drop shortly. I said:

Monday, August 18, 2008
Foreigners selling Fannie and Freddie debt
I wrote here about what seemed to be the irrationally wide spread on Fannie and Freddie debt. We are after the Paulson plan. The US Government has promised it stands behind these entities. But the spreads still widen.
Widening spreads will cause the end - because Fannie and Freddie need to borrow humungous piles of money.
Now Naked Capitalism has a nice post on foreigners selling Fannie and Freddie debt. That seems irrational to me - but it is still happening - and that is not good news for the GSEs.

I expressed my opinion about the irrationality here.

Even then I did not think that the Bush administration would step in and socialise the problem.
The Bush administration is hardly characterised by decisive well considered action. There is an election coming – why not just palm it off on the next guy?

I "missunderestimated" them. Paulson is his own man and whilst George Bush didn’t think it was a bailout Paulson knew better.

I think the bailout was the right thing to do – expressed here. And I am surprised it is so generous (expressed here).

The question will now come down entirely to the “known unknown” – which is how big are the credit losses. I think my estimate here is the best so far anywhere in the market – and I barely think it worth the place in the Blogger computer server. Nobody knows. If they are bigger than about 80 billion the Government will probably wear some losses. If they are less than 80 billion the preferred will probably retain some value. If they are less than 40 billion the common will be a good buy. Unfotunately I come out about 80 billion. That will make the government whole but leave everyone else very distressed. Freddie Mac being worse than Fannie Mae will wind up costing the government money.

I hope this series has helped people. It helped me to write it.

Finally - this bail-out is only worth doing if the spreads on agency debt falls. Funnily enough it still is not - see this post from Naked Capitalism. That looks strange to me. But I have given up disbelieving things because they look strange.



John Hempton

Some quick analysis of what the Frannie bailout means

There is plenty of analysis on the web – and I have read my regular blogs – so I thought I might do something different. Warning this is a long post – and it is coming straight off the typewriter – so there are certain to be errors and misunderstandings. You are getting the fast-version analysis – and my slow version may wind up far more nuanced. I expect to be corrected - and will keep the comments as a rolling update...

I might have a go at working out whether there is any value left in Fannie stock or preferreds. This is by definition heavily speculative and not the sort of thing I would trade on. This is super-rough.

I am also only doing it for Fannie as I have not thought much about the numbers for Freddie other than that everything is substantially worse for Freddie.

The first surprise

The bailout looks more generous for the common than I would have expected and it is fairly generous to the preferred. The government has given Fannie (and Freddie):

· a large line of credit – effectively a guarantee they would remain liquid at least whilst the facility remains – to 2009, and

· a put option on preferred stock whenever its book value goes negative (in other words the right to put preferred only when strictly necessary – effectively a guarantee backed by $100 billion that they will remain solvent

· The most explicit statement yet that the Federal Government stands behind these entities – but with the liquidity support limited to 2009 and the capital support limited to 100 billion for now

In exchange Fannie has given the government

• one billion dollars, paid in preferred stock, not cash
  
  
• 80% of the common equity
  
  
• an indeterminate annual fee which can be paid in preferreds
  
  
• A change in regulation which will force Fannie’s owned portfolio to reduce over time to $250 billion
  
  

That is it for now.

Well that looks generous to me. There is NOTHING here that wipes out the preferred (though its dividend gets suspended pending repayment of government monies). There is nothing here that wipes out the common (yet).

This is Mr Paulson who argued that Bear Stearn shareholders should receive a low price in the bailout not a high price. I cannot see why for instance the warrants were not for 95% of the common or 99% of the common except that maybe they felt for some reason that they needed to get the GSE management on board. [Hint journalists - there is a story there... they gave the GSEs a generous deal to get them aboard and the strategy was different to Paulson's low price strategy... now find the "source" and you got the front page.]

My view: if the government is going to back-stop the risk it should take the upside. It took a lot of it – but by no means all. Then again - maybe there is not much upside.

I know this is a radical suggestion that this is generous because the view around the traps is that the “bailout” knifes the preferreds. Their rating got cut into the Cs. That is funny – apart from a billion dollar sign up fee nothing so far has been put senior to the preferreds and they have a government guarantee for senior capital and senior liquidity. Its not a bad deal at all for the preferreds.

Whether the preferreds ultimately get paid anything of course will depend on the ultimate losses – but we will get to that later in this post.

The reduction in Fannie earnings power

The second big issue is one that almost nobody has much commented on – which is that the owned portfolio of Fannie Mae will shrink over many years to about 250 billion. In the past most of the earnings power of Fannie Mae has not come from the guarantee book – but from the owned book. [See Fannie Mae part 1.] This will reduce the underlying earnings power of Fannie from say 10.5 billion pre-tax to say 4-5 billion. But at a 10% reduction rate for the owned book (after an increase this year) it will take a long time to get there. This “earnings power” is contingent on Fannie being able to issue debt at reasonable spreads – say 30-40bps – on Treasuries. This has not been the case for some time and because the guarantee has not been made explicit it might not even be obvious now…

An upper value for Fannie Mae common

This calculation of earnings power give an upper value for Fannie stock post the bailout. If the “end earnings power” is say 4.5 billion pre-tax then the upper value of the stock is say 45 billion – and that is presuming all the losses have been absorbed. The government now owns 80% of the stock for nominal consideration so the upper value of the currently listed stock is say 11 billion.

If everything thus goes perfectly from here – one day the currently listed stock will be worth 11 billion. That is after all losses have been absorbed, repaid by earnings etc and presuming not further dilution. [I think there will be further dilution - see below...] 11 billion is a somewhere-over-the-rainbow upper value. Given the market cap at close Friday was 7 billion the common holders are getting crushed – but they are not getting crushed by the bailout as such – they are getting crushed by the future losses. And the future losses were there before the bailout!

The common may eventually get crushed by an event-of-default on the preferred to – as I will discuss below.

So how big are the losses in the book

The losses in the traditional mortgage book are the 64 billion (or 250 billion or 40 billion) dollar question. Nobody knows. I had a go at estimating them in Fannie Mae Part III. I got $64 billion but until now I have avoided talking about the $64 billion dollar question. Them big numbers – and they are over the background losses. Lets just plumb for an 80 billion dollar loss number as my (reasonable but speculative) baseline. That assumes a little more on the non-standard mortgages in Fannie's books.

The “fair value” of Fannie assets at the end of the last quarter was negative 5 billion dollars – see Fannie Mae’s Fair Value Balance Sheet as reproduced below.

The Fair Value balance sheet contained a mere 40 billion odd in provisions.

The “Fair Value” of the common – if you believe my highly speculative $80 billion loss estimate – is negative 45 billion. You probably should add straight away another negative $1 billion because the Government took $1 billion up front in the form of a preferred. So call it negative 46 billion. There are some FAS 159 adjustments to this too – so the real negative equity is probably minus 52 billion.

Over the next 5 years (and I will get back to why five years later) the earnings power pre-provision is likely to be something in the order 45 billion. [Why – a little less than 5 times 10 billion – I said this was rough.] So in five years the fair-value of Fannie’s book will be approximately say negative 10 billion. The Fed’s will still have some money in Fannie but not a lot in the scheme of things.

It will need to issue preferreds to the Treasury over time as per the agreement – because the GAAP Book Value of Fannie will approach the Fair Value Accounts and will go negative. But at the end of five years book value attributable to the common will be approximately -10 billion and the Treasury will be looking at losses in the 10 billion range… Even that will be recovered as the underlying earnings power is not going away....

The Treasury will take a big bath on this if

• The spreads on Fannie Mae debt do not dramatically drop. The reason is that unless the spreads drop Fannie have no earnings power and hence little ability to earn the money needed to pay the Treasury back, or
  
  
• The losses are substantially higher than 80 billion.

Both of these are speculative propositions – but I will note in my baseline case the Federal Government roughly breaks even on the Fannie Mae bailout. [Freddie Mac starts in a considerably worse position than Fannie Mae – so on my base-line case the Government will lose considerable money on Freddie Mac.]

Why is five years important?

Five years is important because of the terms of the preferreds. The preferred stock has a standard form – dividends can be suspended for five years without an event of default. The “bailout” suspends the preferred dividend – and none of the preferred holders can file to stop this (yet). They will be able to file in five years and in lieu of their accumulated dividends my guess is that they wind up owning a large part of what is left of the common.

Now note that my baseline case has the government just squeaking most of its money out in five years. Indeed it it might be a bit worse because I have not figured in the extra cost of the government money (at 10% not treasuries plus 30bps).

So there is no way on the baseline case that in five years Fannie will have enough capital to pay back the accumulated interest on the preferred. The preferreds will have a formal event of default and so the rating on them (in the Cs) is correct.

By the end of 5 years there will be something like 35 billion in preferreds outstanding (including accumulated interest). [Again this number is rough…]

The formal event of default will result in the preferreds winding up with common stock. If all the preferreds got converted to common stock the GAAP book value of Fannie would go from say minus 10 billion to plus 25 billion. Within a couple of years (seven years from now) it would get back to some kind of normal capitalisation.

The preferreds however will not own all the common stock. The government is going to want to keep some of its stake and the existing common shareholder probably won’t be wiped out either. Its going to be some form of structured arrangement partly because the government will still own some senior preferreds. My guess is that the preferreds wind up owning say half of it – and the government gets some extra warrants as well. The dilution of the existing common by say 95-98% will then be complete. This does leave the existing common looking very sick indeed. If they do not trade below a dollar quite quickly they are worth a short! That said - if losses are way below base-line in five years the common will look fine.

If the preferreds get half of the new company they will have a value of say half of 45 billion in 10 years. They should trade – in my base case – about 25c in the dollar now. They were trading at about 50c in the dollar a few days ago. My guess is that they will trade below that - but I think they will be fun purchasing at say 10c in the dollar. [Again this is first draft and I won't trade off this analysis until I have had more time to think aout it...]

Nonetheless the preferreds are not gone entirely.

Freddie Mac looks far more problematic for the Government. It’s really stuffed. The government takes a bath there most probably.

J