Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, highlights the two new issues concerning Fannie Mae worth considering at the present time.

Highlights

Fannie MaeThere are two new issues concerning Fannie Mae worth considering at the present time. One concerns the payment of interest on the company’s subordinated debt. The other is a newly released document by a group of economists, many who have held positions in the Administration, which advocates the creation of a new government backed mortgage entity.

The subordinated debt issue is an interesting one. In his book, The Mortgage Wars, ex-Fannie Mae CFO, Timothy Howard, described the discussion that led to the creation of more subordinated debt at the company to shore up its capital position.

Apparently the deal was to bring subordinated debt to a specific level. If this debt combined with equity failed to reach that level the concept was to defer payments of interest on the subordinated debt for five years. Well, the company is not meeting the capital requirement but it is still paying the interest on the subordinated debt. Note the following extensive quote from page 163 of Fannie Mae’s current 10k.

“Under the September 2005 agreement, during any period in which we defer payment of interest on qualified subordinated debt, we may not declare or pay dividends on, or redeem, purchase or acquire, our common stock or preferred stock.

As of December 31, 2008, our core capital was below 125% of our critical capital requirement; however, FHFA has directed us to continue paying principal and interest on our outstanding subordinated debt during the conservatorship and thereafter until directed otherwise, regardless of our existing capital levels.”

What is happening here? In 2005 it was agreed that that the company should conserve it funds until it met or exceeded its basic capital requirement. Instead of doing this, the company kept paying interest on its subordinated debt.

By doing this the company was paying out funds that could have been used to rebuild its financial position. Most importantly, by making these payments, it made possible the payment of huge dividends on the senior preferred. By making these payments, which presumably never should have been paid, the government has effectively wiped out the company’s equity rendering it insolvent.

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Fannie Mae & Freddie Mac Reform

This last point may have been a key reason for the publication of a new monograph entitled A More Promising Road to GSE Reform. It was written by five economists and market participants, some of whom had high positions in the current Administration. They have made their suggestions because as they state it:

“… we believe that a fresh approach like this is needed to move the conversation forward, because the system can tread water only so long.”

Simplifying the proposal it makes two core suggestions:

  • First, merge Fannie Mae and Freddie Mac into a new secondary mortgage corporation that would be backed by the full faith and credit of the United States government. Presumably they forgot that we already have one of those called Ginnie Mae.
  • Establish a system of selling the risk in the mortgages guaranteed by the new corporation in the private sector so that the government is only at risk in catastrophic situations.

There is no mention as to what should be done for or to the current stakeholders in Fannie Mae and Freddie Mac. What these men are primarily interested in is averting the crisis that may be coming if there is no resolution to the GSE problem.

Conclusion

It is possible that the woeful financial situation of the GSEs may force action by the government before the catastrophe hits them and the housing industry. I think that this is very likely sooner rather than later. First quarter results could be very disappointing for both companies.

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