Monday, September 8, 2008

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.



Anonymous said...

Nice post, you work fast.

One other issue in terms of future earnings power is the likely significant reduction in the "g-fee" charged to the I-banks packaging the loans. Since the dual mandate of promoting affordable housing financing and maximizing shareholder value has been reduced to the former, this is a logical step (given this new priority). My guess would be the first adjustments to the fee structure would be on the more borderline collateral which dealers in the past might not have shown into the GSEs because of prohibitively priced g-fees (not all conforming loans are created equal).

Conveniently, the Treasury will now have a bid for "new GSE MBS", as vague as the purchase program currently stands. This combination should encourage an easy arb trade for dealers to wash through existing loan books, or bid on new loan packages that they would otherwise not have touched given current conditions.

The net result for FNMA and FHLMC is that they will increase their credit risk on a loan level basis for some of this new business, while being left which less matched capital to absorb future losses.

Anonymous said...

thankyou, thankyou! Very helpful to get this analysis.

So... Why is the global market up 3%? Do they think that the government is bailing out wall street? Or that RE prices will stabilize? Or just that it feels so good when the beating stops... if only for a minute?

Andrew Clavell said...

I am pretty sure the pref dividends are non-cumulative (see here for 1 particular class: Is this not how they received full equity credit for capital calculations?
Redeemable, cumulative prefs are just another form of sub debt.

So if dividends are stopped (at directors' election), there is no build up as you assume, for the purposes your "5 year exit" calculation....(I think)

John Hempton said...

I apologise about the preferreds - being non-cumulative. Most bank prefs are cumulative. I know - I have at at times even been paid the accrued interest in a lump sum.

There is a tradition where the face value is $50 the pref is non-cumulative - as per the example that you gave - and where the face value is $25 the pref is cumulative.

But you are right - this pref does not have a five year limit and is non-cumulative.

that changes the analysis somewhat.


John Hempton said...

A further correction:

The R series is face value 25 - non cumulative.

Must be something in GSE legislation regulation.


John Hempton said...

Further follow up -

This a typical bank preferred{8FC37C4B-E762-410F-8993-4BA5017BFF20}&dist=hppr

Note it is cumulative and has the same terms as described in the main post...

I have yet to find a cumulative fannie one yet.



John Hempton said...

You are indeed 100% correct - all of Fannie's preferreds are non-cumulative.

Fannie specifically disavows the cumulative structure for regulatory purposes here

The structure I talked about was common for banks - and unknown for GSEs.




David Merkel said...

Hey, good job, John. Appreciated the analysis. A lot of this will hinge on how foreign investors view the new implicit guarantee, and how mortgage losses proceed from here.

My guess is that losses get much worse from here, but that this action has a marginal positive impact on the ability of people able to put down a down payment to finance the purchase/refinance of homes. It doesn't help those that are inverted on their mortgages, or can't make a decent down payment, though.

Anonymous said...

You say the common should have been wiped out even more than it was, but they did not ask for this bailout. If real losses eventually wiped them out then too bad for them, that's the risk they take. But now the government has wiped them out 80% for the government's own benefit. What happened to property rights? The government has taken 80% of the capital owned by the shareholders of these companies. If that is for a social benefit, fine, but the government ought to buy out the shareholders, not just steal from them. You say at one point that the shareholders have been wiped out by future losses. That is silly. We won't know for a couple of years whether that was the case or not. What if we find out two years from now that the losses clearly are not turning out to have been enough to wipe out the equity? Do the warrants get canceled? No, but they should.

What has been accomplished by confiscating the propert of GSE shareholders? The most you can possibly hope for is that mortgage rates will come down 50 bp or so, and that could have been achieved without the 80% dilution. The 80% is purely punitive in nature - it serves no other purpose in this deal than to punish shareholders. What exactly did the shareholders do wrong to deserve to have their capital stolen from them? Barney Frank wanted the GSE's to stay levered up. The GSE's could have sold off their retained portfolios to de-lever but government would not allow it. THe GSE's did not have to take on more mortgaes earlier this year but the government begged them to - even LOWERING their capital requirements. THe gov't begged the GSEs to take on larger mortgages, and they did. Then the government encouraged them to raise capital. FNM did, and is just as screwed now as is FRE. Paulson completely suckered the buyers of FNM's last capital raise.

If the shareholders for some reason deserve punishment, why don't the debt holders? Aren't they just as responsible for whatever horrors the GSEs have inflicted on the world?

Why hasn't the equity of LEH and MER been wiped out? THey did dumb things and the gov't had to "bail" them out by providing access to the discount window.

All the crowing about how shareholders deserved to be wiped out here is misplaced. The gov't has just stolen private property. Just because you like the result does not make it right.

Anonymous said...

From the NY Sun:

Imagine if the Bush administration, having decided that gasoline prices are too high, decided to nationalize ExxonMobil. The federal energy secretary held a Sunday press conference to announce that the Bush administration had replaced the company's management, that the company would henceforth be run with the goal of reducing gasoline prices for drivers, and that any profits the company made would be the property of the federal government, which would now control 80% of the company. As for the company's existing shareholders, they are out of luck — they won't get any more dividends; they won't even get a chance to vote on the deal.

Substitute mortgage prices for gasoline prices and you get a pretty good sense of what the Bush administration and its secretary of the Treasury, Henry Paulson, did over the weekend in respect of Fannie Mae and Freddie Mac. The administration decided that its interest in low mortgage rates as an artificial boost to housing prices was more important than the property rights of the shareholders of Fannie Mae and Freddie Mac. So without even so much as a shareholder vote, the companies were nationalized.

Anonymous said...

"So without even so much as a shareholder vote, the companies were nationalized."

The difference is that FM&FM were GSEs - in many aspects, already an arm of the government. I thought that was a bad idea, just looking at it (private profit, public risk).

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