Freddie Overstated Capital Cushion / Bailout Imminent
A: First week of football, bailout of Fannie & Freddie, ahhhh the excitement. And man, how pathetic am I. Anyway, here is the latest and its not surprising. Both Fannie & Freddie for whatever reason have been marking their assets to model, not to market. When Merrill sold off their distressed assets at a reported 22 cents on the dollar, arguably 5 cents on the dollar, it issued in price discovery for what these distressed assets were currently worth on the open market. The ricochet of mark downs were not occuring at the GSE's, making their books appear at first glance to be stronger than they really were. I wish I had an intern to help me research all this for more visual discussions on these very important topics.
Via NY Times, "Loan Giant Overstated the Size of Its Capital Base":
The government’s planned takeover of Fannie Mae and Freddie Mac, expected to be announced as early as this weekend, came together hurriedly after advisers poring over the companies’ books for the Treasury Department concluded that Freddie’s accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter.Just amazing. Price discovery continues, mark to market write downs will continue, as the cycle progresses to the next stage. As I stated July 28th:The details of the deal have not fully emerged, but it appears that investors who own the companies’ common stock will be virtually wiped out; preferred shareholders, who have priority over other shareholders, may also wind up with little. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.
"This is how the cycle goes. A frozen secondary mortgage market leads to forced sales of assets that would not otherwise be sold. As firms stack their toxic holdings into the imaginary accounting blanket of Level 3 assets (which I told you back in NOVEMBER of 2007 would become a household phrase), some firm has to ruin the party and forcibly sell their bad holdings for a bad price in the bad open market that is not really very open anymore. And then, have the audacity to sell more shares and dilute current shareholder value. How dare they! And now, we get a fresh new glimpse at the price that the frozen marketplace will currently pay for assets that I both don't want to own or sell. Sweet, thanks, great job Merrill Lynch. Now I need to MARK DOWN my bad assets to the low level that you just sold them at! Damn bastards."Freddie's capital cushion appeared better and was overstated because the marks on their toxic holdings were not updated as of the latest discovery trade. When you update them to the new value of the bad assets, the capital cushion becomes too low.
Welcome to free market capitalism, or lack thereof. The full details on the bailout is imminent. If market is to rally on this announcement, we probably will NOT get any event rate cut. An event rate cut is my phrase for the fed acting to sooth the markets that are reacting to a very negative event. You would think this would classify, but financials will likely surge and credit spreads likely will tighten significantly on this news without any cut. We'll see.
Comments (17)
Great call man. You have been saying it for weeks. The GSEs are bankrupt. Bet those put options are making you feel good right now. This is the beginning of the monetizing of the bad debt crisis. Cross your fingers and toes that we can get through it without a currency crisis and hyper-inflation.....we're probably going to have to wait 6 months or so for the intervention mojo to wear off to get the vote on that.
Posted by Jeff | September 6, 2008 7:12 PM
Ha. Yea got the FNM puts OCT $5s. Wish I had way more. We still dont know details but I would think that Paulson & Co has to punish at least the common. Crazy all around.
Did you expect it this soon? We just talked about this Fri afternoon, what, 2 hours before the announcement?
Posted by Noah | September 6, 2008 7:15 PM
It's real hard to time these things, but after reading the Bill Gross piece I just feel like the market is now finally getting it that if the government is going to successfully bail out the system, they need to do it soon before all confidence is destroyed. They need to pull in all the vulture money to help recapitalize the system. If things get real hairy on the unemployment side with a severe headline number GDP recession or a run on a major bank, the vultures will go home and count their cash or convert it to gold and put it in their basements. I expect a more comprehensive approach to this whole mess as opposed to the serial fire extinguishing. I see bank rehabs, and a new RTC program plus a more comprehensive housing market bailout. I hope the feds put this stuff together quickly.
Posted by jeff | September 6, 2008 8:29 PM
Noah,
I agree about the un-assisted Monday rally, it was already happening Friday afternoon. In fact the financials were relatively strong all week and broke through technical resistance after hours Friday.
So is it your considered opinion that financials (let's say, XLF) has seen it's lows for this cycle and will be trading above it's 200 day average from here on out, leaving materials, energy and the rest of the real economy sectors to carry the bear market load? Is it time for trapped bears to unload SKF on any weakness?
Posted by Steve | September 7, 2008 12:36 AM
Steve - I think the financials, XLF, will rally as this bailout is interpreted as another removal of systemic risk, uncertainty, and as a result, buyers may come in to buy distressed paper, assist the cycle, and spreads tighten. Good for financials. Rally will prob hold for a bit. But then I am getting short big time. I think we re test lows and plow through them. Just my opinion.
We still did not see the after effects of this storm on main economy.
Posted by Noah | September 7, 2008 8:13 AM
Somebody on one of the blogs put it quite well. Capitulation will happen when the market finally realizes that, in a larger sense, what happens today doesn't really matter (i.e. bailouts, price of oil, today's bank failure). Capitulation will occur only when we wake up and realize just how horribly we are screwed fundamentally. I'm afraid the road to financial health is going to be a long and painful one, and I'm disheartened, because I think it could happen again. Ah, if only studying history were as remunerative as getting an M.B.A.
Posted by brenda | September 7, 2008 8:39 AM
Brenda - exactly. But irrational stocks will likely rally AS LONG AS PREFERRED IS SOMEHWAT RESCUED. IF PREFERRED & COMMON GET WIPED OUT, NOT SO SURE ABOUT RALLY.
Will be interesting to hear all the details. Paulson should give pain somehwere as it was Paulson who insisted on the $2/share Bear buyout, that was originally going to be $5-$6. He said it had to be MUCH LOWER than that.
Posted by Noah | September 7, 2008 8:51 AM
Noah, you're right. I guess I was kind of assuming preferred would be bailed out. Without that, the scenario does change quite a bit. Everybody was mocking the NYTimes reporting yesterday, but they may have the last laugh (if inclined toward gallows humor).
Posted by brenda | September 7, 2008 10:50 AM
Jeff - yes I feel same way. New RTC to buy mortgages. As you said, will bring in new money.
Posted by Noah | September 7, 2008 11:02 AM
So? What do you guys think?
Posted by Noah | September 7, 2008 11:44 AM
So, the question of the moment remains...
What will this do to mortgage rates? I imagine that conforming loans that will be sold/packaged to Fannie/Freddie will fall, perhaps even significantly.
I have NO idea what this will do to Jumbo loans, and look forward to your thoughts/insight...
Posted by Wes | September 7, 2008 2:20 PM
Noah-
First, us taxpayers are screwed yet again, no doubt.
However, the NY Times is arguing that by the gov't taking over FNM and FRE, borrowing costs to the former GSEs should fall enough to take a point off of conventional rates (perhaps we've seen some of that over the past couple weeks). That does make sense to some extent.
What do you think?
Posted by Andrew | September 7, 2008 2:44 PM
P.S. Congrats on the puts!
Posted by Andrew | September 7, 2008 2:49 PM
I dont think so. If it does, it would be temp..This was done to PREVENT a systemic financial crisis that would have come out if nothing happened. That simple. The action was done to attempt to make our future unravel without a serious incident.
Posted by Noah | September 7, 2008 3:14 PM
It sounds like the Treasury is coming in senior to the common and the preferred, through a Senior Preferred investment. The dividends on the common and existing preferred have been suspended. This would imply that there is no bailout of the common and junior preferred.
The Treasury is also getting warrants for just under 80% of FRE and FNM common. I don't know what the strike is, but suspect/hope that Hank "$2 Bear" Paulson priced these well in the money and diluted the crap out of the existing SHs. In any event, even if the warrants are at market, there is no "bailout" here unless the warrants are exercisable (i.e., in the money), in which case it's not a bailout at all but a windfall to the taxpayers.
That's my read.
Posted by yournamehere | September 7, 2008 4:54 PM
not suspended, eliminated the statement says. I think that is what ylou meant.
bailout, rescue, backstop, whatever. Its telling of the times.
Posted by Noah | September 7, 2008 5:21 PM
Noah-
Looks like rates are dropping pretty nicely. Wouldn't you think that the spreads would remain low given that it is the US Gov't behind them?
Well, that's the good news, but the real bad news is probably yet to come. The banks are on the hook in a big way with the preferred- how many bank failures might this cause?
Posted by Andrew | September 9, 2008 2:22 PM