Saturday, July 12, 2008

More on Fannie, Freddie and IndyMac



Before I discuss IndyMac, take the time to listen to this excellent Bloomberg interview (click here to watch) with Joshua Rosner of Graham Fisher (website is being redone) and Len Blum of Westwood Capital. Both commentators discuss whether Fannie Mae and Freddie Mac are adequately capitalized and whether or not they will be nationalized.

As far as accounting rules and statutory capital guidelines governing these GSEs, they both agree that neither GSE is adequately capitalized, especially Freddie Mac (Juxtapose the above views with the statement released by Freddie Mac on Friday stating it is "adequately capitalized").

On the issue of nationalizing Fannie Mae and Freddie Mac, Rosner was quoted in an article as stating in a note that nationalization of the two companies is unlikely because that would double the Federal deficit, weaken the dollar and raise Treasury's cost of funding. However, he said the GSEs are in trouble and regulators may choose other options, such as placing GSE assets into FDIC receivership.

But Blum believes that the GSEs, especially Freddie Mac, have dug themselves a deep hole and need a bailout:

"Freddie is insolvent and Fannie is running on fumes. They're going to end up being nationalized. The entire financial web depends on them. If they failed, it would make Bear Stearns look like a picnic."

Apart from this interview, I also read four excellent commentaries on the GSE debacle which can be found on the Aleph blog, Mish's Global Economic Trend Analysis blog, Paul Krugman's blog and Greg Mankiw's blog.

I quote the following from the Aleph Blog (click here):

Thus, I argue that a guarantee of senior obligations of the GSEs would not be horrendously costly. Let the preferred and common equity be wiped out. Let the subordinated bondholders sweat. The losses at the senior level should be small.

The benefits of such a guarantee would be big, though. Who invests in Fannie and Freddie direct and guaranteed paper? Banks, insurers, stable value funds, foreign investors, and more. Do we want a “domino effect” that might lead to further financial failures? I think not. Arresting the losses at the senior level, and eventually folding Fannie and Freddie into GNMA preserves many other financial institutions.

And this from Mish's Global Economic Trend Analysis blog (click here):

If China and Japan were dumb enough to invest in US agencies (and they were), then China and Japan should suffer the consequences, not US taxpayers.

From Paul Krugman's blog (click here):

Will Fannie Mae and Freddie Mac have to be bailed out by taxpayers? I have no inside information, but I’d say yes, for two reasons.

First, as Reinhart and Rogoff document, big financial crises always end with an expensive bailout of the banking system. It happened in Sweden, it happened in Japan. Why should we be different? Except that in this case banks proper took on very little of the risk; Fannie and Freddie, on the other hand, took on a lot of it.

Second, the housing bubble was immense; see the figure above, taken from the always excellent Calculated Risk. Fannie and Freddie only guaranteed conforming loans — loans that weren’t that big, didn’t have exotic financial features, and required a substantial downpayment. But so what? If real prices of houses in places like LA return to historical norms — and there’s no reason to think they won’t — many, many borrowers with conforming loans will end up with big negative equity anyway, and this in turn will produce a lot of defaults.

This crisis is a long way from being over.

And finally from professor Greg Mankiw's blog (click here):

Because the housing GSEs are so large, the risk they face is important for the entire financial system. GSE debt is widely held by other financial institutions. Even a small mistake in GSE risk management could have ripple effects throughout the economy.

My own thoughts are that the U.S. government will do nothing for Fannie Mae and Freddie Mac shareholders but they will bail out the bondholders. What choice do they have? If these agencies fail, nobody will guarantee U.S. mortgages, sending mortgage rates through the roof. But even if the U.S. government bails out these mortgage agencies, some worry that the nation will lose its coveted AAA status, which would also force interest rates up to attract foreing investors. This would surely lead to global economic turmoil.

Finally, the $32 billion failure of U.S. mortgage lender IndyMac proves that this credit crisis is far from over. According to Bloomberg, IndyMac became the second- biggest federally insured financial company to be seized by U.S. regulators after a run by depositors left the California mortgage lender short on cash.

Importantly, the article cites Christopher Whalen, managing director of Institutional Risk Analytics, a market research company in Torrance, California as stating the following:

"IndyMac is the vanguard, the precursor of more stuff coming. It's not surprising to see IndyMac resolved. What you have to ask is what's coming next. It's going to be a wave of medium to bigger-than-medium institutions.''

I quote the following from Square Feet, a commercial real estate blog:

IndyMac is the largest thrift ever to go under in the United States, and the second largest bank to go under.

The FDIC will probably take a huge hit on it and then flip the bank out to an acquirer. Until they find a buyer though, the FDIC is running the show.

The failure comes after their June 30th announcement in which IndyMac said it was ceasing all commercial lending activity.

It is likely that this won’t be the last failure as market conditions continue to deteriorate in many markets. There is over $1T worth of ARM mortgages that will be coming due over the next year or so, and as those loans also turn into junk, more banks will feel the pressure to raise capital to prevent a fold-up.

In fact, according to CNN (click on video above), 90 other banks and financial institutions are currently on the FDIC watch list (the FDIC will not publicize this list).

The message to investors is clear: this credit crisis is still in its early stages and it will get a lot uglier before it stabilizes.
Investors should remain underweight financials in their portfolios and short them outright if any significant relief rally develops over the next few weeks or months (if you can't short financials, invest in the SKF Ultrashort Proshares ETF which is up 76% year-to-date as financials got slammed in the last few months).

In the meantime, keep some other Ultrashort Proshares on your radar screen, including the
UltraShort Basic Materials ProShares (SMN), the UltraShort Oil & Gas ProShares (DUG) and the UltraShort Real Estate ProShares (SRS).

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