Freddie and Fannie are getting nationalized

A prediction I first broached here in May in my post Question: How is Fannie Mae a AAA company? is finally coming to pass: Freddie Mac and Fannie Mae are getting nationalized.

UPDATE: The U.S. Government takeover is now a done deal. See my post on the details of the merger with a plethora of links to other news sources.

NOTE: The deal will have bad implications for shareholders and preferreds. See My post on the implications on the preferreds.

Oh, aren’t you happy Bill Gross?

Back in May, I said

The only answer is the implicit government guarantee. Fannie Mae and Freddie Mac are too important and too big to fail. In fact, the U.S. government may need to ‘re-nationalize’ these organizations to conduct a clean up of the mortgage mess.

With many subsequent events having passed since then making Fannie and Freddie yet more fragile, the time has come and Hank Paulson has taken the step.

Bloomberg said today:

Treasury Secretary Henry Paulson met with regulators and executives of Fannie Mae and Freddie Mac today as the Bush administration prepared to announce a plan to prop up the firms hit by $14.9 billion in losses the past year.

It’s about time.

The list of reasons why the Fed and the Treasury needed to intervene are increasing by the day, with each new revelation more srious than the last:

• Freddie and Fannie are essentially bankrupt institutions. Stock market investors triggered a massive selling wave that engulfed the entire financial sector when shareholders began to believe a bankruptcy was imminent and that shares would go to zero. Even investing sage Warren Buffet is on record as saying a bailout is going to happen. On a CNBC interview on August 22nd, he said “you will see some action fairly soon”and “the game is over.” I don’t think there is any doubt what he thinks.
• The bond market thinks the same thing as credit spreads widened on Fannie and Freddie paper even after an explicit unlimited backstop from the Treasury was made. Fannie and Freddie preferreds have been downgraded by Moody’s to reflect this risk as well. Preferreds and shareholders will likely be wiped out in bankruptcy.
• Bond King Bill Gross seems to be getting more agitated by the day by the credit situation, just recently opining that he might go on strike and refuse to buy any more paper. PIMCO is stuffed to the gills with GSE securities. Gross wants to ee a payoff
• The Chinese Central Bank has been hemorrhaging losses due to the loss of value in their GSE assets. The bank has only $3 billion in equity capital left despite its trillions in assets. The losses on their portfolio have made them need to go hat in hand to the Chinese Treasury for a bailout. They are very angry about this situation.

It doesn’t get more serious than all of this. Now the Feds are going to put an end to our misery.

The plan is likely to involve putting at least one of the companies under government control in a conservatorship, according to a person briefed on the discussions. The move may also result in changes in the leadership of Fannie and Freddie, said the person who spoke on condition of anonymity.

Pacific Investment Management Co., manager of the world’s biggest bond fund, and other large investors may put in their own money once the Treasury decides to inject government funds, said Newport Beach, California-based Pimco fund manager Bill Gross, in a Bloomberg Television interview.

The meetings come a month after Paulson hired Morgan Stanley to advise on any use of taxpayer funds to recapitalize Fannie and Freddie, which account for almost half of the $12 trillion U.S. mortgage market. A government takeover would be the latest attempt to blunt the impact of the yearlong credit crisis, after the Federal Reserve provided financing for Bear Stearns Cos.’s takeover by JPMorgan Chase & Co.

Paulson gathered with Federal Reserve Chairman Ben S. Bernanke, Fannie Mae Chief Executive Officer Daniel Mudd, Freddie Mac CEO Richard Syron and Federal Housing Finance Agency director James Lockhart in Washington. The Treasury plans to brief Democratic presidential candidate Barack Obama‘s campaign team tomorrow and has contacted Republican contender John McCain‘s staff about its intentions.

`Open Their Wallet’

“They have to open their wallet,” Gross said, adding that the Treasury will want to act before the FHFA releases an assessment of Fannie Mae’s and Freddie Mac’s capital later this month.

The Washington Post reported that government officials told Fannie and Freddie they plan to put them into a conservatorship, where common stock would be diluted while not wiped out, citing sources it didn’t name. Debt and preferred shares would be protected, and the government would make quarterly injections of funds as the companies’ losses warranted, the Post said.

Washington-based Fannie and Freddie dropped in after-hours trading. Fannie dropped $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70.

Paulson has made no public comment on the backstop for Fannie and Freddie since Aug. 10, when he reiterated he had “no plans” to use his authority. Shares in Freddie and Fannie have dropped 9 percent and 16 percent, respectively, since then as investors and analysts called for Paulson to clarify his intent.

`Making Progress’

“We are making progress on our work with Morgan Stanley, FHFA and the Fed,” Treasury spokeswoman Brookly Mclaughlin said today in Washington.

Should any public money be injected into Fannie and Freddie, “the management and board should immediately be replaced, multimillion-dollar salaries should be cut, and bonuses and other compensation should be eliminated,” McCain wrote in a July.

Obama last month echoed that position, saying he had “no sympathy” for Fannie and Freddie’s CEOs. The government has to decide whether the companies should be made private or taken “out of the profit-making business,” he said.

Mudd and his aides have also been meeting at the FHFA, which oversees the two firms, with catered food scheduled for delivery at the agency through the weekend.

Fed Role

Bernanke participated in today’s meetings because the central bank was given a consultative role in overseeing Fannie’s and Freddie’s capital under the July legislation.

Mudd and Syron must approve of any government intervention under the law, unless the FHFA declares that either firm has insufficient capital. The legislation gave the Treasury the power through the end of next year to extend unlimited credit to or make equity purchases in the firms.

The FHFA was scheduled to release its own assessment of the companies’ capital levels as early as this week as part of a quarterly appraisal of their finances.

Analysts have speculated that the Treasury would wipe out common shareholders, while seeking to shield preferred stockowners from total loss. Fannie and Freddie preferred shares are typically owned by banks and insurance companies. Their $5.2 trillion of debt outstanding is held by investors including Asian central banks, and would probably be guaranteed, analysts said.

Raising Capital

A specific fallback plan should Fannie and Freddie fail may enhance their ability to raise new private capital, said Alex Pollock, fellow at the American Enterprise Institute in Washington and former president of the Chicago Federal Home Loan Bank.

“Treasury’s main concern is the debt markets, and if it was to say that it will do whatever is necessary to keep Fannie and Freddie running, the better it is for their funding,” Pollock said. “If Treasury makes it clear they have a plan ready to go, that would certainly help.”

Mclean, Virginia-based Freddie Mac’s board this week relaxed its ownership rules to make it easier for investors to take a large stake in the company. It rolled back a rule in its bylaws that precluded owners with a 20 percent or more controlling interest from voting without the approval of all other shareholders.

The two companies need to sell billions of dollars of bonds each month to pay off maturing debt, and have continued to issue securities this week.

Mudd at FHFA

Mudd was accompanied by Fannie General Counsel Beth Wilkinson and Chairman Stephen Ashley in his visit to FHFA this afternoon.

FHFA spokeswoman Stefanie Mullin declined to comment, as did Mark Lake at Morgan Stanley.

The Wall Street Journal reported earlier that Paulson is close to completing a plan that includes changes of senior management, according to an unidentified person familiar with the matter. The Journal also said the plan involved what it called a creative use of the Treasury’s powers, without citing anyone.

–Bloomberg News

This is a huge story that must be resolved as soon as possible in order not to cause a market panic. Let’s hope the Treasury and Federal Reserve can pull this off smoothly.

Expect to hear much more as time goes along.

Related posts
Quote of the day: 27 Aug 2008 – China
Senator Bunning blasts Bernanke at Senate hearing
Moody’s Cuts GSE Preferred Stock Ratings
Fannie, Freddie to get $15 Billion from U.S. government
Fannie and Freddie: Washington Post articles back to 2005
Question: How is Fannie Mae a AAA company?

For other posts on Fannie and Freddie see ‘GSE ‘ tag.

Sources
Paulson Meets With Bernanke, Fannie, Freddie Chiefs – Bloomberg
Buffett predicts game over for Fannie and Freddie – Times Online