Reality Check: Fannie Mae & Freddie Mac Go To Zero (FNM, FRE)

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If you have watched Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), you know what has gone on.  These are technically Federal National Mortgage Association (NYSE: FNM) and Federal Home Loan Mortgage Corp. (NYSE: FRE), but soon they will disappear from the New York Stock Exchange and head over to the OTC Bulletin Board.  This is not new, but a reality check shows that Fannie and Freddie are worthless.  These companies have avoided bankruptcy because of necessity and because of higher powers that be.  Fannie and Freddie do not even constitute being considered call options.  In some twisted sense, these will equal way out-of-the-money warrants with upside only if we return back to the days of carefree lending and even more greedy carefree borrowing.

CNBC reported that the bill for taxpayers is $145 billion, but that could be only a mere appetizer at an all you can eat buffet of misery from losses in Fannie Mae and Freddie Mac loans.  The Congressional Budget Office estimates the losses may reach $400 billion.

The housing data so far has yet to show any real improvements.  It turns out that the end of the homebuyer credit suddenly killed the demand.  Yep, it was a temporary fake market bolstered by Uncle Sam’s incentives.

The government has these two GSEs in conservatorship.  They should both be in receivership, but the U.S. government does not want these trillions of dollars at stake here to end up as direct obligations on the national balance sheet.  Keeping these two companies alive keeps the red ink from bleeding directly on to Uncle Sam’s right-hand side of the ledger books.

By stabilizing these two (pieces of you know what) in conservatorship, Uncle Sam can honor some future obligations and keep others off the books.  This form of takeover of Fannie Mae and Freddie Mac kept additional waves of losses from swooping through the banking system, foreign trading partner system, and the pension system.

The interesting notion is that these two will continue to operate as Freddie Mac and as Fannie Mae.  For now.  There are often calls  to abolish these two agencies.  The problem is that these obligations have to end up somewhere and there are real assets in the system in the form of mortgages outstanding with millions of borrowers who actually do manage each month to send in their P&I checks.

There are almost countless dollars of mortgage-backed securities, CMOs, and even CDOs still outstanding and still operating.  Again, some in America still managed to keep paying their debt each month.

Alan Greenspan once said that these two should be collapsed (nationalized) and rolled into as many as five to ten entities and sold off to the public.  It is a nice thought, but the balance sheet issue is impossible to get away from.  The U.S. Treasury does not want these obligations on the books.  Not even for a day.  Because the U.S. still owns its own printing presses, unlike the troubled nations inside the E.U., the ultimate Triple-A rating is not really at stake.  But the implied Triple-A ratings would disappear overnight to the investing world if Uncle Sam had to print money to back these two failed entities.  In short, it is just cheaper the send money the way of these two government charities on an as-needed basis.

Once Fannie Mae and Freddie Mac leave the NYSE and end up on the OTC-BB, there is likely going to be a single trend.  Lighter and lighter volume will be followed by lower and lower prices.  Even many of the Fannie Mae and Freddie Mac direct debtholders won’t likely be getting 100-cents on the dollar.  It all depends on the debt obligation, how it was issued, and how the government treats the New-Co or the New-Cos that rise from these ashes.

CNBC threw around the notion that a $1 trillion price tag could come the way of Fannie and Freddie if we get another downward price wave in housing.  They were right about another thing, or two things: taxpayers don’t want to foot the bill, and both entities are in need of a major overhaul.

The Case-Shiller 10-city index rose 0.7% in April compared with March, but the 20-city index rose by 0.8%.  Unfortunately, if you adjust for those pesky seasonal factors, the 10-city index rose by only 0.3% and the 20-city index rose a mere 0.4%.  The figures do look better versus a year ago.

As noted earlier and in earlier reports, housing is just not showing a real recovery.  Sure, things are less-bad.  Things are not continuing to slide indefinitely into oblivion.

Have your tried selling a home or talking to a realtor about selling your home?  Even in the few “good” local housing markets, let’s just say politely that the first thing that occurs is a reality check at the level of the seller.  The realtors then also prep their clients for the second reality that price drops may be necessary if no real interest is seen in the first 30 or 45 days.  What this all is leading up to is that the borrowing public is either upside down in their houses or they have to pay to get out from under a mortgage.  At least that is the case for most who bought from 2005 to the present.

Mortgage rates are back near the lows our life, assuming you can qualify.  Those who have ample liquidity and a solid credit background can write their own ticket for the house that they want to purchase.  That hasn’t changed, although the difference this year compared to summer of 2008 or 2009 is that certain select markets with the right zip code and right area ate holding pat.  The problem there is that Fannie Mae and Freddie Mac are not the lending conduits because those markets generally fall under the whole loan classification rather than the conforming loan category.

The first-time-borrower market that was able to get into housing in the last 9 months did get in under the conforming loan limits, so they were likely going through Fannie or Freddie.  As long as there is no real crash, those newer pools of borrowers are likely much better credit scores than the millions of the 2005 to 2007 seasons of borrowers.

Our belief that these were worthless goes far before the calls last October.  Once the government yanked the rug out from under the structure, that was it.  That was still the case in February-2009 when systemic nationalization was being thrown around as a risk.

So, why does all of this translate to Fannie Mae and Freddie Mac being worth ZERO on the shares?  Quite simply, the ZERO is a mathematical exaggeration.  Once these go to the OTC-BB, they can literally trade down at $0.01 or $0.05 indefinitely.  The real value will still be zero of course, but the implied upside for any price above zero comes with the notion that the economy could return or even that inflation comes back in a hurry.  Ten percent inflation per year would be one short-term cure for housing.  It would be like treating a case of the flu with syphilis, but the argument can be made that a brief period of inflation would help IF it was short and containable.

After the U.S. finally decides what to do with these entities, then the real value of what is ultimately left will be known.  That value will almost certainly be nothing for the common and preferred stockholders, but there will be value for the direct debt obligation holders.  This does assume that contract law will still be honored.

Being involved in companies where the stocks de-list and go the way of the OTC-BB is rarely a win.  In fact, many investors from retail to institutions are outright barred from investing in the OTC market.  It is not just the common shares. All last week some of the “Most Down” were the preferred shares of Fannie Mae and Freddie Mac which still trade on the NYSE.  If you think trading will dry up in the common stocks, wait until you see most of the preferred share issues.  There will be a myriad of five-ticker Fannie and Freddie stocks.

Is it 100% certain that Fannie and Freddie both disappear and that these both go to zero?  No.  It only looks about 95% certain that this will be the outcome.  That being said, Fannie Mae and Freddie Mac common stock could continue trading or go to the Pink Sheets even if these get collapsed into a single entity.  Enron, GM, Adelphia, and many others have traded as Pink Sheet stocks long after they are gone.  At that point the shares become long-term warrants on any future lawsuit proceeds.

And what would be a good name for the collapsed entity?  Trannie Mae sounds about right.  Not many would want to own that name.

There is one caveat here.  Shareholders could fight a delisting and delay that event if successful.  Fannie Mae shares went from $0.92 to $0.56 the day the announcement was made.  The shares it at $0.35 today.  Freddie Mac was above the $1.00 mark at the time, and those shares are now at $0.40.  The big difference there is that any block would only be temporary.  Ultimately there is still probably a 95% chance that the hangman wins out here.

Stay tuned.

JON C. OGG