Saving Fannie and Freddie

The WSJ's front page this morning features an important-sounding 1,500-word article on contingency plans for Fannie Mae and Freddie Mac, recapitulating Katie Benner's article in Fortune yesterday. What would the government do if the companies ran into trouble? What could it do? We learn that people in the Bush administration have been asking such questions, which is prudent and sensible. But we don't learn what kind of answers they might be leaning towards.

What, exactly, is the problem? Well, as William Poole is keen to point out, if Fannie and Freddie were forced to liquidate their assets tomorrow, they couldn't raise enough money to pay off their liabilities.

Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.

Mish is on a similar track:

Fannie Mae holds or guarantees over $5 trillion in mortgages. A mere 1% decline would wipe them out. Is that adequately capitalized? I do not think so.

This is maybe less scary than it seems, since there's no chance that either entity is going to be entering a forced liquidation of anything. And one look at General Motors is enough to show that a company with negative net worth can continue as a going concern more or less indefinitely, even without taxpayer support. Or, to put it another way, being "wiped out", in Mish's terms, is interesting from an accounting point of view but doesn't automatically trigger the need for drastic actions like nationalization or multi-billion-dollar government loans.

What's more scary is the share-price dynamics. It makes sense that the share prices of these companies have fallen as investors anticipate large and dilutive new equity offerings. But the problem is that the further the share prices fall in advance of the new issues, the more dilutive those issues are going to be. And at some point those issues become effectively impossible:

Egan estimates that Freddie alone will need to raise $7 billion over the next two quarters due to writedowns and losses. But the company's market capitalization stands at $8.7 billion.
"An investment banker would be hard pressed to raise an amount of money nearly equal to the value of the entire company," Egan says.

On the other hand, the GSEs do still seem to be able to be able to issue a large amount of debt. Issuing 30-year bonds would be much cheaper than issuing equity, and would serve much the same purpose, if regulators were happy to treat the proceeds as equity, at least for, say, the next decade.

My gut feeling is that the government is being prudent, war-gaming worst-case scenarios in terms of fiscal policy just like it does in terms of foreign policy. Ultimately it's conceivable that Fannie and Freddie might need to be nationalized, which in a way would only make sense since no one ever believed that they were really private companies in the first place. At that point they would stop having to mark their assets to market, and might well never lose money on a cashflow basis. But the effect on the total US national debt would be extremely unpleasant, and I'm sure that no one in any administration would want to go down that route except as a very last resort.