Its not official, but it looks like the endgame is near for the two GSE's.
I have been writing about these companies at great lengths over the past few months. This was the main reason the stock market took a giant dump today.
The move down was triggered by a Barron's article on the GSE disaster that essentially said the equity holders of these companies are toast and the companies will be nationalized. Here was the headline from Barron's. Unfortunately I don't have a link:
"The Endgame Nears For Fannie and Freddie
By JONATHAN R. LAING
The almost inevitable government recapitalization of Fannie Mae and Freddie Mac will likely wipe out investors—and management.IT MAY BE CURTAINS SOON FOR THE MANAGEMENTS and shareholders of beleaguered housing giants Fannie Mae and Freddie Mac . It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?"
My take:
The market did not like hearing this news. Folks, if the GSE's go down, getting a loan will be almost impossible. Interest rates will go through the roof because there simply is no capital out there that is available for lending. You can find it but its going to cost you.
IMO, Fannie/Freddie are either going to go out of business, or be forced by the bond market to be nationalized which will result in a drastic change of their lending standards. They will be forced to de-leverage significantly because it will be the taxpayer that foots the bill for their losses. Either way, the days of bubble lending are gone.
Why?
Because this would dramatically reduce the money thats available for lending. Rates would then go through the roof because capital has become so expensive to lend for banks.
I would not be surprised to see double digit mortgage rates by the end of the year if the two agencies blow up or are forced to dramatically reduce their lending. Its a virtual guarantee that one of these two things are going to happen.
The bond market sent a message today to the GSE's:
Reuters reported that demand for Freddie's most recent debt auction was anemic:
"NEW YORK (Reuters) - Freddie Mac's latest debt sale drew anemic demand on Monday, a day after Barron's reported an increasing likelihood the U.S. Treasury may essentially take over Freddie and rival Fannie Mae.
The weekly financial newspaper said such a move could wipe out existing holders of the largest U.S. home funding companies' common stock, with preferred shareholders and even holders of the two government-sponsored entities' $19 billion of subordinated debt also suffering losses.
Bonds issued by the two 'agencies' sharply underperformed Treasuries, and their shares slid by more than 9 percent on the New York Stock Exchange.
Merrill Lynch also weighed in on Freddie Mac on Monday, saying it will likely raise fresh capital in the third quarter, comprised of at least 50 percent common stock. Merrill also cut its price target on the company
."Lukewarm was my overall characterization," Nancy Vanden Houten, analyst at Stone & McCarthy Research Associates, said in an email of Freddie Mac's $4 billion debt sale Monday."
Another report on the Fannie/Freddie debt
This is from Dow Jones
"NEW YORK (Dow Jones)--The cost of protection on the less-secure subordinated debt of Fannie Mae (FNM) and Freddie Mac (FRE) rose significantly Monday as fears reignite that the U.S. Treasury Department will recapitalize the two companies, leaving existing shareholders, and potentially holders of this debt, with nothing.
Holders of the mortgage giants' subordinated debt are also concerned they could be left empty-handed in such a move, according to Margaret Kerins, managing director at RBS Greenwich Capital.
As a result, credit default swaps on subordinated Fannie and Freddie debt Monday afternoon were seen at 330 basis points, or $330,000 to insure $10 million of debt for five years, Kerins said. This is 50 basis points, or $50,000, wider than Friday's closing level, and higher than levels around 303 basis points, or $303,000, seen earlier Monday, according to data from broker Phoenix Partners Group in New York.
The current levels are dramatically wider than levels seen in the middle of July when investors first became concerned about an increasing chance of default in the subordinated debt. On July 10, the cost of protection was at 241 basis points, or $241,000, according to administrator Markit."
Final Take:
Now although the news looks grim for the two GSE's, there is still a lot that needs to play out here. China owns a ton of this mortgage debt and the US badly needs China to continue to be an investor here.
What surprises me is it seems like the traders in the bond markets seem to be trading as if the US government is not going to pull the trigger and nationalize the $5 trillion in debt that the the two GSE have so irresponsibly run up.
I personally believe that in the end, the government will step up to the plate and nationalize these two companies and then draw a line in the sand.
As I described above, the only lending that will be done going forward will be 20% down. The loan will also be no more than about 36% of your income. You better have a great credit score as well.
The reaction to this event in the housing market will be violent as housing prices will free fall to levels at which buyers can qualify with the new lending standards that will be seen in the mortgage market.
The reaction to this on Wall St. will be horrifying. Massive losses will need to be taken by the banking system, housing will capitulate, and the consumer will reign in spending after losing such massive amounts of money in lost housing "equity".
The sad reality is this what needs to be done in order to save the financial system. Without buyers in the debt markets for Fannie/Freddie paper, the game is over. The US government will not let this happen IMO.
Bottom Line:
If the government decides to backstop the two GSE's then you can expect the US to lock up this $5 trillion and throw away the key. You might as well put a fence around this debt because it will no longer be growing. It will be guaranteed by the US because the we need the investors that own it like China to continue to buy debt.
We cannot afford to piss these people off and allow $5 trillion in debt to fall drastically in value. China would run for the hills and put their money elsewhere. The poor demand in todays debt auction says it all. China is not stupid and will reign in the purchasing of this debt until this is worked out.
The days of bubble borrowing are over folks!
Here is what I predict will happen.
The $5 trillion ponzi debt machine will be shut down immediately. The next step will be to throw this debt into a closet and guarantee it so we keep our big investors whole. Sadly, our tax dollars will be what guarantees this debt, and we will be the ones paying for the losses as a lot of this debt gets defaulted on.
This is the only solution that I see. I say this because if the government doesn't backstop this debt, it looks like the bond market has zero desire to continue buying it. The US simply can't afford to let this happen so they will bend over and take the hit.
A new housing market will be born after this occurs. Lending will be tight, expensive, and done only with customers that have money to put down with excellent credit scores.
The reprocussions of this are huge, and equities will end up paying the ultimate price. Lets hope this is enough to get us out of this mess.
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