Wednesday, August 13, 2008

Insolvent versus profoundly insolvent – Fannie Mae Part II

The origin of this post came about because of a blog post about Freddie Mac being “profoundly insolvent”. Infectious Greed thought it too fine a distinction between “insolvent” and “profoundly insolvent”. As this post shows I think there is such a distinction.

Fannie Mae and Freddie Mac right now have vast books of prime mortgages for which the credit is deteriorating at an increasing rate. I gave some delinquency sequences in this post and asked people to estimate where the losses peaked.

Nobody was prepared to take a guess but several people quoted back JP Morgan. If JP Morgan is right (and I will guess they probably are) delinquency is more than doubling from here and losses are more than tripling. But it is a blind guess as explained in the modelling post. It remains very bad for US domestic financials – and the more prime your business the more your credit losses will deteriorate. That does not bode well at all for the GSEs.

Fannie Mae and Freddie Mac came into this crisis with a bad history because of stuff-ups in interest rate risk management. This was explained in Part I.

Fannie Mae’s shareholder equity includes a massive tax asset – reflecting that their past sucks. [I was asked whether sucks was a technical term the other day...]

There is no question that the situation is difficult. Moreover given the thin equity they start with and the large books of Alt-A business (even if it is higher quality than average Alt A business) it is likely that the companies are insolvent.

There I said it. But that still doesn’t mean it makes sense to short them.

In my Fannie Mae Part 1 post I suggested that pre-tax, pre-provision income of an unimpaired Fannie Mae is about 10.5 billion dollars. Call it 6 billion post tax and some minimal normal provisions. If someone were to waive a wand and give you a well capitalised and well managed Fannie Mae tomorrow you might pay 13 times earnings for it – say 78 billion. [A government guarantee - implicit or otherwise - has a lot of value...]

The problem is that Fannie Mae is not well capitalised (or well managed) now. If you buy it you are almost certainly going to have to chip in equity, perhaps a lot of equity.

Under no circumstances is it profitable to chip in more than 78 billion in equity because at the end you are left with something that is worth 78 billion in total. If the shortfall at Fannie is more than 78 billion then Fannie is “profoundly insolvent”. It is so insolvent it is not worth saving. That doesn’t mean it won’t be saved. More than a few financial institutions have solved their problems by leaking out the bad news over time and doing more capital raising than their end net worth. But if the losses are more than 78 billion the first capital injection is not going to be sensible and Fannie can only survive if the capital market is prepared to throw good money after bad.

However if you “only” have to throw in 10 billion dollars then Fannie is a steal right now. The market cap is only 8.6 billion – and you would only be paying 18.6 billion for something worth 78. You would get a 4.5 bagger out of the stock. That I think is the upper limit for Fannie Mae stockholders now.

I am beginning to find a way of modelling this – subject to the radical uncertainty in the modelling post.

But that is for Part III.


1 comment:

rc whalen said...

First, let me lay claim to "profoundly insolvent."

If you want to adequately capitalize "Frannie," you need to raise a couple of hundred billion in new capital. Buying the equity of the GSEs before loss rates peak is a really bad idea. I still think that nationalization is the only course -- especially when you consider that we need to raise half a T$ to recap the banks. Until we recap the banks, private credit flows are going to be negative and the economy will suffer accordingly

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