Fannie, Freddie. and fears of a market meltdown

Transcription

1 Fannie, Freddie and fears of a market meltdown Su mmer 2008 Concerns about the financial stability of Fannie Mae and Freddie Mac have sent shares of the two companies plummeting by around 75 percent in the past year, ultimately forcing the federal government to legislate the ability to step in and support them. Now, investors are wondering if a bailout by the federal government a move many industry analysts say would be disastrous for the world s financial markets will be necessary. How did we get here, and where are we going? Navellier & Associates, Inc. One East Liberty, Third Floor, Reno, Nevada 89501,

2 THE EARLY DAYS OF FANNIE AND FREDDIE The Federal National Mortgage Association (FNMA), which is usually referred to as Fannie Mae, and the Federal Home Mortgage Corporation (FHMC), which is usually referred to as Freddie Mac, make and guarantee home loans. Fannie Mae was founded in In the wake of the Great Depression, the housing market collapsed, and private lenders were wary of making home loans. Franklin Delano Roosevelt s New Deal designed Fannie Mae to save the mortgage market by providing local banks with money to finance home loans. In its early days, Fannie Mae operated much like a national savings and loan. Then, in 1968, President Lyndon B. Johnson privatized the company to remove it from the national budget, a move that was most likely the result of fiscal pressures created by the Vietnam War. At this point, Fannie Mae began operating as a government-sponsored enterprise (GSE), which is a private company, owned by shareholders and listed on a stock exchange, but at the same time financially protected by the federal government. In 1970, to prevent a monopoly from forming, the federal government created another GSE, Freddie Mac. Today, Fannie Mae and Freddie Mac buy home loans from lenders, then hold them in their portfolios or repackage them into bonds that are called mortgage-backed securities. Fannie Mae and Freddie Mac primarily make money by charging a fee on loans they have repackaged into mortgage-backed securities. Purchasers of the companies mortgage-backed securities pay this fee in exchange for Fannie Mae and Freddie Mac taking on a number of risks. Perhaps the greatest one is credit risk, which is the possibility that the borrowers of the underlying loans will default. In essence, Fannie Mae and Freddie Mac guarantee that the principal and interest on loans underlying their mortgage-backed securities will be paid even if the borrower defaults. As GSEs, Fannie Mae and Freddie Mac have myriad government protections, perhaps the most notable of which are access to a line of credit through the U.S. Department of Treasury and exemption from Securities and Exchange Commission (SEC) oversight. A problematic history The companies exemption from SEC oversight has, throughout the years, been of great concern to many investors. To understand why, it is important to realize what a significant role Fannie Mae and Freddie Mac play in the nation s and even the world s economy. Fannie Mae and Freddie Mac are the country s largest buyers of home loans. Together, they own or guarantee around $5 trillion in mortgages, which is close to half of the nation s mortgage market. Because they promise to step in and make good on their loans if the homeowners default, the companies are guaranteeing trillions of dollars worth of loans. That makes them major players in the nation s housing market.

3 At the same time, the companies status as GSEs and resulting exemption from SEC oversight means they are not required to report any financial difficulties that they may be having to the public. They are the only two Fortune 500 companies with such a privilege. Those two factors worry many investors because if one of the companies should experience difficulty or worse yet, collapse it s possible that no one would know until it was too late. Such a scenario could be disastrous for shareholders of the companies for obvious reasons but also for the the entire credit market. Fannie Mae and Freddie Mac, and the mortgage-backed securities they issue, are not explicity backed by the U.S. government. But any possibility of their failure would likely lead to a meltdown in the world credit markets because if their guarantee is deemed worthless, millions of people worldwide who hold their mortgage-backed securities would panic, try to sell, and ultimately lose money. As a result, the investment community generally agrees that the federal government will not allow the collapse of Fannie Mae and Freddie Mac. And if the federal government takes over the companies, U.S. taxpayers could be on the hook for hundreds of billions of dollars. While these fears may seem overdone, they are not completely unjustified, as the companies have been plagued by scandal throughout their history. In 2003, for example, Freddie Mac revealed that it had understated its earnings by almost $5 billion, and was fined $125 million. And in 2004, Fannie Mae came under investigation for widespread problems in its accounting practices, including shifting losses so senior executives could earn generous bonuses. Recently, worries about Fannie Mae and Freddie Mac have increased due to the state of the housing market. Before we explain why, let s look at the history of the subprime crisis. THE SUBPRIME CRISIS From 1998 through 2005, nationwide housing prices rose at an average annual rate of around 7.25 percent or 10 percent, respectively according to the Office of Federal Housing Enterprise Oversight (OFHEO) Index and the S&P/Case-Shiller (S&P/ CS) Index, the two most widely cited measures of housing prices. Even more dramatic numbers were seen during the last two years of the housing market boom, 2004 and 2005, when the OFHEO Index rose 9 percent per year, and the S&P/CS Index rose more than 13.5 percent per year. As a result, from 2004 to 2006, everyone wanted to get in on the action, including borrowers who could not qualify for traditional mortgages. These borrowers existed all over the country, of course, but the two most notable groups of borrowers were concentrated in the sunbelt states and the upper Midwest. The sunbelt states such as Arizona, California, Florida, Nevada, and Texas had booming real estate markets, and non-traditional mortgages helped borrowers afford larger homes by offering lower payments. In the upper Midwest states such as Illinois, Indiana, Michigan, and Ohio housing prices were not rising significantly, but deteriorating labor market conditions (such as in the automotive industry) created a number of borrowers who could not qualify for traditional mortgages. In response to this demand, lenders made credit available to these borrowers. Instead of getting traditional mortgages, borrowers took out subprime mortgages, which are made to individuals with questionable credit histories, and Alt-A mortgages, which are made to individuals who don t have documented income. These mortgages also had a number of features that were designed to keep monthly payments low. For example, the commonly used 2/28 adjustable rate mortgage (ARM) had an initial interest rate set for two years

4 and a floating interest rate thereafter. There were also interest-only mortgages, negativeamortization mortgages, and something that may seem bizarre as we look back option mortgages, which allowed the borrower to decide how much he or she wanted to pay each month. Lenders and companies such as Fannie Mae and Freddie Mac took these subprime mortgages, and, as they did with all mortgages, created mortgage-backed securities. Sometimes, those securities had different tranches, each with different streams of income. For example, the first tranche s income stream might be relatively secure, the second tranche s income stream less so, and the third tranche s income stream even less so. And losses were allocated from the bottom up. With this kind of structure, companies that repackaged mortgage-backed securities were able to obtain investment-grade ratings on billions of dollars of securities that had relatively unsecured credit that is, subprime mortgages as underlying collateral. That created a whole new audience for mortgage-backed securities namely, investors who had no expertise evaluating the underlying collateral of mortgage-backed securities and instead went solely by the rating. In a vicious circle that created even more demand for subprime mortgages, subprime mortgage originations grew from $35 billion in 1994 to $140 billion in 2000, an average annual growth rate of 26 percent, according to the Federal Reserve Bank. Similarly, subprime originations as a share of total mortgage originations grew from 5 percent in 1994 to 13.4 percent in As noted above, this continued through Then, in 2006, everything fell apart as two economic situations combined to create what many industry insiders say was the perfect storm: interest rates began to rise and housing prices began to weaken. First, let s look at interest rates. As noted above, a 2/28 ARM is originated with a low initial interest rate. After two years, the interest rate resets to a level based on the then-current six-month LIBOR rate plus a margin. It resets at least annually thereafter. As an example of how this impacted the subprime borrower, take the typical interest rate on a 2/28 ARM in early 2005, which was around 5 percent. At the time, ARMs taken out by subprime borrowers typically reset to LIBOR plus around 6 percent. With LIBOR around 5 percent, it meant loans charging 5 percent interest quickly jumped to 11 percent. A homeowner with a $200,000 mortgage would see his or her payment jump from around $1,200 to more than $2,000. Now, we all know what borrowers who cannot make their mortgage payment do: they refinance or sell their home. This time, though, they could not refinance because interest rates were rising, and they could not sell because the housing market was plummeting. In 2007, sales of existing single-family homes fell by 13 percent, the largest amount in 25 years, according to the National Association of Realtors. At the same time, the median home price dropped 1.8 percent to $217,000 for the entire year the first annual price decline on record, which goes back to Lawrence Yuan, the chief economist at the National Association of Realtors, called the decline unlike any seen since the Great Depression. Borrowers who could not make their mortgage payments had run out of choices, and delinquencies and foreclosures on subprime loans started to rise. In the first quarter of 2006, the seasonally adjusted delinquency rate for subprime loans was percent, according to the Mortgage Bankers Association. In the first quarter of 2008, that number had risen to percent. At that time, subprime ARMs represented 6 percent of U.S. loans outstanding and 39 percent of U.S. foreclosures started.

5 WHERE ARE WE NOW? When the subprime meltdown first began, many economists thought it would be contained within But the crisis continues to unfold. First, it does not appear that lenders despite their claims to the contrary rediscovered credit quality after the subprime woes first surfaced. Subprime loans that originated in 2007 are defaulting at even faster rates than those originated in 2005 and 2006, according to Moody s. Seven percent of 2007 subprime loans were defaulting within the first three months of origination, compared to just 4 percent of 2006 subprime loans. Moreover, we are at the point at which many ARMs reset. It has been estimated the value of subprime loans resetting to a higher interest rate will be $500 billion in 2008, up from $400 billion in If that is indeed true, we will likely continue to see high default and foreclosure rates through 2008 and into Supporting that, foreclosure filings grew by 53 percent year-over-year in June, according to RealtyTrac, which monitors default notices, auction sale notices, and bank repossessions. Nationwide, 252,363 homes received at least one foreclosure-related notice in June one in every 501 U.S. households, and more than 71,000 properties, were repossessed by lenders. The problem was nationwide, with foreclosure filings increasing year-over-year in all but 11 states. Nevada, California, Arizona, Florida, and Michigan continued to have the highest foreclosure rates. In fact, in Nevada, one in every 122 households received a foreclosure-related notice in June, more than four times the national rate. What does it mean for our old friends Fannie and Freddie? As the credit markets have dried up, Fannie Mae and Freddie Mac have played an essential role in the country s mortgage market. Essentially, they have been the lenders of last resort, providing much-needed liquidity to the housing markets. As a result, banks and other lenders have been able to make loans they otherwise wouldn t have been able to make, and make them at lower rates. But now that homeowners are defaulting and being foreclosed on at alarming rates, Fannie Mae and Freddie Mac are being forced to make good on their guarantees. Since last July, they ve reportedly posted combined losses of close to $13 billion, and investors are worried there are more losses to come. Worries about the companies subprime exposure have led their stock to decline for months, but the panic hit a crescendo in mid-july when a report from a Lehman Brothers analyst warned that a proposed accounting rule change would require the two companies to keep significantly more capital on hand. The Financial Accounting Standards Board is reviewing a rule that might force financial firms to take mortgage-backed securities that are currently off their balance sheets and place them on their balance sheets. If Fannie Mae and Freddie Mac have to do so, Fannie Mae would have to add $46 billion to its reserves, the report said, and Freddie Mac would have to add $29 billion. In today s tight credit market, that kind of cash could be hard to raise. Indeed, Mark Zandi, chief economist for Moody s Economy.com, has said that the companies may need to issue more stock to raise money, which would dilute the value of existing shares. Adding insult to injury, not long after the Lehman Brothers report came out, a former Federal Reserve governor said he believes Fannie Mae and Freddie Mac are already insolvent and urged the federal government to take them over. Granted that governor has

6 long been critical of Fannie Mae and Freddie Mac, but it was a serious statement because if the government takes over the companies, shareholders would likely get nothing and U.S. taxpayers would be on the hook for all the companies debt. The sell off began. Immediately after the markets opened on July 11, shares of Fannie Mae and Freddie Mac fell more than 47 percent from their already battered closing price the day before. Although they made up much of their losses, with Fannie Mae finishing the day down 22 percent and Freddie Mac finishing the day down 3 percent, both companies stock ended down around 45 percent for the week and 75 percent for the year. As evidence of the companies importance to the U.S. economy as a whole, the problems at Fannie Mae and Freddie Mac also weighed on the broader markets, at one point forcing the Dow Jones Industrial Average down past the 11,000 mark for the first time in nearly two years. How fundamental are the problems? Suddenly, Fannie Mae and Freddie Mac were the topic of the day. Media pundits debated if the companies were really in trouble, or if the sell off was just the result of a temporary panic. It seemed like everyone had an opinion. As noted above, many thought the companies were insolvent. Others, however, said the companies were doing just fine. For example, the Office of Federal Housing Enterprise Oversight (OFHEO), the primary federal regulator for Fannie Mae and Freddie Mac, said the two companies were adequately capitalized, meaning they have enough cash on hand to stay in business. And in a July research note, a Keefe, Bruyette & Woods analyst wrote that the OFHEO already requires reserves for off-balance sheet securitizations, and because of those requirements, in part, the pair would not be affected by new accounting standards. Even Senator Christopher Dodd, the chairman of the Senate Banking Committee, has defended the strength of the two companies. But the bigger question on investors minds is: If the companies are indeed in trouble, will the federal government take advantage of the legislation it authorized, step in, and save them? IS A GOVERNMENT BAILOUT LIKELY? As noted above, the law that created Fannie Mae and Freddie Mac explicitly says the government does not guarantee the loans. But there is a widespread belief that Fannie Mae and Freddie Mac are backed by some sort of implied federal guarantee. Vernon L. Smith, 2002 Nobel Laureate in economics, has even created a new name for such an arrangement, calling Fannie Mae and Freddie Mac implicitly taxpayer-backed agencies. As a result, a majority of investors believe that Fannie Mae and Freddie Mac are simply too important to the economy for the federal government to let them fail, and policymakers would step in to prevent a default. Policymakers have echoed that belief. On July 13, the Federal Reserve said it is giving Fannie Mae and Freddie Mac the same access to Federal Reserve Bank of New York funds as commercial banks and Wall Street firms. And Treasury Secretary Henry Paulson proposed a plan to extend credit to Fannie Mae and Freddie Mac or purchase equity in the companies, if necessary.

7 They play an important and vital role in our economy and housing markets today, and they need to continue to play an important role in the future, Paulson told legislators. Congress ultimately authorized the plan, which allows the Treasury Department to provide an unlimited line of credit to Fannie Mae and Freddie Mac and take an equity stake in either company over the next 18 months. Although Paulson called the plan a backup facility [that] hopefully would never be used, one analyst noted that blank checks almost always get filled in and cashed. So, despite much recent talk about the government s bailout of Fannie Mae and Freddie Mac, all the recent legislation did, as noted above, is authorize intervention by the Treasury Department if it becomes necessary. So far, the government has spent only $94,000 on the so-called bailout paid to Morgan Stanley to provide market analysis and financial expertise in connection with its rescue plan. How likely is government intervention? Sharp losses at Fannie Mae and Freddie Mac continued in August, with both companies posting larger-than-expected second-quarter losses $2.3 billion for Fannie Mae and $821 million for Freddie Mac. The companies continue to insist they can make it through these troubled times. Freddie Mac, for example, said it can handle $40 billion in credit losses through next year if it obtains $5.5 billion in additional equity, but it is waiting for market conditions to improve to raise that money But many analysts say $5.5 billion when market conditions improve will be too little too late, and either investors will be massively diluted, or the company will be nationalized. Indeed, the 53 economists polled in a recent Wall Street Journal survey said there is a 59 percent probability that the Treasury Department will have to step in. When asked how the government should handle the situation with Fannie Mae and Freddie Mac, 68 percent of those surveyed by the Wall Street Journal said the companies should raise capital privately. The core belief behind that position is that it is the companies own poor mortgage lending practices that helped put the country in the subprime crisis, and if they falter as a result, the government should let them fail. After all, to many, there is no crisis that cannot be made worse by government intervention. By stepping in to save Fannie Mae and Freddie Mac, it can be argued, the government will be creating an even bigger financial pickle. But for every position there is an opposing position. Former Fed Chairman Alan Greenspan recently criticized Fannie Mae and Freddie Mac as fundamentally flawed institutions that privatize profits and socialize losses. They should have wiped out the shareholders, nationalized the institutions with legislation that they are to be reconstituted with necessary taxpayer support to make them financially viable as five or 10 individual privately held units, and auctioned off, he said.

8 Navellier & Associates is a premier money management firm dedicated to finding the market s best growth stocks. We ve guided individual and institutional clients for more than 20 years with a disciplined, style-consistent investment approach designed to maximize returns while avoiding excessive risk. Navellier uses a sophisticated mathematical strategy to identify companies with strong profitability and growth characteristics. Our dynamic system adapts to market trends, adjusting for the conditions the stock market is rewarding. Many of our competitors try to emulate indexes; we focus on outperforming them. Our portfolios have a low correlation with their benchmarks, thereby increasing diversification and decreasing risk for index, core and satellite, and multi-manager investment structures. Our strategies are best suited for long-term investors. Navellier & Associates was founded in 1987 by acclaimed growth analyst Louis Navellier. We are an independent and employee-owned firm, with approximately $4.5 billion in assets and a dedicated staff of 50, including a seasoned management team. Our top portfolios are still managed by the very same professionals who launched them many years ago. We are committed to providing exceptional client service, innovative online investment tools, and leading market research. Navellier & Associates is based in Reno, Nevada. Navellier & Associates, Inc. One East Liberty, Third Floor, Reno, Nevada 89501,

9 Fannie, Freddie Update Government takes over Fannie & Freddie september 2008 Government takes over Fannie & Freddie The speculation is finally over. On September 7, the U.S. government announced one of the most sweeping interventions in the financial markets since the Great Depression a multi-part plan to essentially take over mortgage giants Fannie Mae and Freddie Mac and the $5 trillion in home loans they back. Let s look at the details of the plan and what it means for debtholders, stockholders, and the U.S. economy. Details of the plan The bailout plan, announced jointly by the Treasury Department and the Federal Housing Finance Agency (FHFA), contains multiple remedies. Conservatorship: First, Fannie Mae and Freddie Mac will operate under the temporary conservatorship of FHFA, which means that the FHFA will run both companies until they are solvent. (Under the conservatorship, the companies current CEOs, Fannie Mae s Daniel Mudd and Freddie Mac s Richard Syron, will be replaced with Herb Allison and David Moffett, respectively. Allison is the former chairman and CEO of TIAA-CREF and former president of Merrill Lynch. Moffett is the former vice chairman and CFO of U.S. Bancorp and former senior adviser to private equity firm Carlyle Group.) Preferred stock purchase: Second, the Treasury Department and the FHFA will purchase up to $200 billion in the companies preferred stock ($100 billion in each company). This preferred stock will be senior to the companies existing preferred and common stock but subordinate to other outstanding debt. Mortgage-backed security purchase: Third, the Treasury Department will purchase mortgage-backed securities from Fannie Mae and Freddie Mac in the open market. Secure lending facility: Fourth, the Treasury Department will create a secure lending facility for Fannie Mae and Freddie Mac (as well as the country s 12 federal home loan banks, which advance funds to more than 8,000 member banks). The facility will expire at the end of In exchange for backstopping Fannie Mae and Freddie Mac in this way, the government will receive $1 billion of each company s senior preferred stock and 79.9% of each company s common stock. Dividends on both preferred and common shares will be eliminated in an effort to save around $2 billion per year. Over

10 Impact The government s plan marked the end of a period of extended uncertainty about the fate of the mortgage giants, but there was good news and bad news for the companies debtholders and shareholders. On the positive side, the bailout boosted the value of both companies debt. On Monday, September 8, spreads between the companies debt and equivalent Treasury bills fell sharply to levels lower than their historical averages meaning investors considered it far less risky to invest in the companies debt than they did before the bailout. Indeed, on September 11, Fannie Mae sold a record $7 billion of debt in the form of two-year notes. The debt was initially sold at a 0.70 percentage point risk premium over comparable Treasuries to yield 2.896% but when the buying continued in the secondary market, the risk premium fell to 0.66 percentage points over Treasuries. On the negative side, the bailout is undoubtedly a major blow to stockholders, which include some of the country s largest financial institutions, from banks to mutual funds. By essentially purchasing 80% of both companies common stock, the government left common stockholders with the remaining 20%, or one fifth of what they owned on September 5. This diluted the value of the shares. Meanwhile, holders of the companies $36 billion in preferred stock may fare even worse. They d already seen the value of their securities fall significantly, and many now consider the shares worthless since dividends have been eliminated and the government s preferred stock is senior to theirs. After the bailout announcement, Standard & Poor s cut its ratings of the companies preferred stock to junk status. As for the move s impact on the U.S. housing market, the Treasury Department s purchase of mortgage-backed securities could help lower interest rates on home loans, which rose this summer to their highest level in a year. That, in turn, could help reduce the overall cost of owning a home and help cushion the decline in housing prices. It was no surprise, then, that Wall Street responded to the news with its biggest rally in months. The Dow Jones Industrial Average jumped more than 340 points within minutes of the opening bell on Monday, September 8. Financial stocks led the surge as shares of many investment banks rose. It s debatable, of course, whether investors should be so cheerful. It makes us wonder if they re forgetting that as American taxpayers, they re essentially on the hook for the bailout and are now responsible for $5 trillion in questionable securities Navellier & Associates, Inc. One East Liberty, Third Floor, Reno, Nevada 89501,