PrefBlog

More excitement and speculation regarding Fannie and Freddie today, with some rather vague television commentary:

The companies’ preferred securities are typically held by insurance companies, mutual funds and banks, analysts said. That may cause Paulson to stop short of eliminating their holdings in any government intervention.

“The common shareholders will probably be completely wiped out,” Paul Miller, an analyst at FBR Capital Markets, said in a Bloomberg Television interview. “Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also.”

The mechanism for wiping out preferreds was not specified – even the gloomiest commentary Naked Capitalism could dig up did not make Fannie’s net worth significantly negative. Forced sales of inventory could make things worse, of course – but would any responsible receiver or creditor’s committee do this?

Freddie Mac is in a much worse position, according to a somewhat more credible commentator:

Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac, former St. Louis Federal Reserve President William Poole said in an interview. 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.

It should be noted that all this kerfuffle isn’t just of interest to bloated plutocrats: the troubles are being passed through to retail mortgage rates:

Rates on average 30-year fixed mortgages rose to 6.37 percent this week, about the highest in six years, as yields on bonds guaranteed by Fannie Mae and Freddie Mac increased to almost the highest since 1986 relative to Treasuries. More than 70 percent of new home loans are bought or guaranteed by the government-chartered companies, known as “prime” mortgages.

I will note, yet again, that I am not taking a view on the merits or lack thereof of the Fannie and Freddie prefs – but the matter holds some general interest, at the very least, for preferred share investors because it’s an example of a situation in which the common dividend of a financial corporation has been cut and the prefs have plummetted. And I won’t say that the resolution of the problem will set a precedent … but to some extent, it will set a benchmark.

Besides, it annoys me to read stuff like: “Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also.” without any indication of the mechanism or rationale underlying “wipe out” and “lot of pain”. Just once, it would be nice to see some actual analysis!

In further fallout from the unwinding of irrational exuberance, CMBS spreads are widening:

Yields on commercial real estate securities relative to benchmarks rose to near record highs on concern that Riverton Apartments, a high-rise complex in Manhattan’s Harlem neighborhood, will default on a loan.

AAA rated commercial mortgage-backed bonds widened about 37 basis points to 305.57 basis points more than 10-year swap rates during the week ended yesterday according to data from Bank of America Corp. A basis point is 0.01 percentage point.

The gap, or spread, jumped after a trustee report showed payments wouldn’t be made in September on a $225 million loan on the 1,230-unit Riverton.
…
Almost 93 percent of the New York property’s units were rent stabilized when the loan was originated, according to a JPMorgan report on Aug. 15 from analysts led by Todd. The owners intended to deregulate 53 percent of all the apartments by 2011, more than doubling the average monthly rent on those units from $894 to $2,261.

Only 10 percent of the units in the 12 buildings were converted to fair-market rents as of July, according to the Aug. 13 report from trustee LaSalle Global Trust Services Ltd. in Chicago.

Maybe the investors can run crying to mommy.

There were sixteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Update: A bit more speculation on the Fannie/Freddie prefs was reported by Bloomberg:

Small, regional banks may have the most to lose from the stumbles in Fannie and Freddie, and Paulson may risk bank failures unless he protects preferred stockholders, said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. The impact on the preferred holders “may be an important driver” in Paulson’s decisions, Jersey said.

“Any wipeout of the preferreds could have implications for the capital of the greater financial system and these regional banks that might have reasonably precarious capital situations,” Jersey said. “You don’t want to make that worse if you’re the government.”

This nuance was noted by Accrued Interest in a post last Monday. Back to Bloomberg…

Treasury probably will get preferred shares as part of any bailout, eliminating the value of the common shares and causing “a lot of pain” for preferred shareholders, who will rank behind the government in payments and may have their dividend cut, according to Friedman Billings Ramsey & Co. analyst Paul Miller in Arlington, Virginia. CreditSights Inc. analyst Richard Hofmann in New York said holders should “brace” for a deferral of dividends.

The Treasury may wait until Fannie and Freddie’s capital is so eroded that regulators can put them into a receivership, said Andrew Laperriere, managing director at International Strategy & Investment Group, a money management and research firm in Washington.
…
Paulson must also weigh whether hurting preferred shareholders would cripple the $350 billion market that banks across the country also rely on for financing, said CreditSights’ Hoffman. Banks sold $76 billion of preferreds this year to bolster capital after more than $500 billion of credit losses and writedowns

Well … at least there’s been a bit of discussion of the possibilities! The trigger could be an inability to roll debt:

If either company has trouble selling bonds to finance maturing debt, Paulson’s hand may be pressed. They have about $20 billion of unsecured debt due on average every week, with more than $220 billion maturing by the end of next month.

A takeover could also be triggered if either company fails to meet its regulatory capital standards, to be released by the Federal Housing Finance Agency next month.

It should be noted that a failure to meet regulatory capital guidelines – which, as has been noted repeatedly – are pretty lax to begin with, is not the same thing as insolvency. Even Naked Capitalism was able to get that one right:

Mere solvency is not an appropriate standard for the GSEs. In their role of providing/guaranteeing mortgages, they have to be able to fund at the very best rates. That means they need to be an AAA credit, or at worst, a very strong AA. Mere solvency is BBB, perhaps even BB or B. Simply being solvent doesn’t cut it.

But … mere solvency does pay off the preferreds.

So … here’s my take on the most likely scary scenario:

• GSE can’t roll debt on terms that allow them to make a profit
• Treasury buys senior prefs, convertible into common in X years at $1
• GSE cuts dividend on junior prefs, for an indefinite period

With respect to the “indefinite period” part … it would be in the company’s best interests for the highly dilutive conversion to take place as soon as possible, since this would – presumably – reduce the dividend outflow. But it may also be assumed that no holder in his right mind will convert for as long as he gets a fat dividend while retaining convertability. Treasury might – possibly – account for this and

• Keep the conversion period short
• Step up the conversion price within the conversion period

In any event, it may be assumed that dividends to the junior prefs would resume very shortly after conversion of the senior prefs.

Have a look at the books, make up your own minds! I am not taking a view on the investment merits of the GSE prefs – but I will observe that the market can usually be counted upon to grossly overreact to adverse news; and (provided one does one’s homework, makes only bets that are favorable according to fundamentals, and KEEPS THOSE BETS SMALL AND DIVERSIFIED) … taking an informed contrary opinion (as opposed to an opinion that is simply contrary) can often be rather profitable.

This entry was posted on Thursday, August 21st, 2008 at 11:16 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.