Running Out of Options
With the recent collapse in share price, both GSEs are going to have a very difficult time raising capital. You won’t find many buyers of the stock after its recent dive. And issuing debt doesn’t seem to be much of an option.
The last thing investors want is to buy debt from companies involved in the mortgage mess. Even if they could find buyers, they would be forced to issue a very high coupon, which would add another drag on cash flows.
For Fannie and Freddie to have any chance at all to raise additional capital, it’s likely they’ll have to issue some type of convertible preferred stock, with very attractive features (warrants, enhanced voting rights, very attractive conversion rate, etc.)
The Truth Won’t Always Set You Free
All of this aside, we need to remember there’s no real evidence that either GSE is flirting with insolvency. However, we cannot ignore the market sentiment. We must keep in mind that market perception can create a self-fulfilling prophecy.
I have seen market panic or even rumors destroy companies many times in the past. The stock gets beaten down, and then rating agencies downgrade the debt, causing higher interest payments to be made due to the increased risk. Finally, the company cannot raise capital since the stock is so low.
If the stock remains low over an extended period, rating agencies sometimes downgrade the company and its outstanding debt. Sometimes debt covenants are triggered, forcing immediate payment of debt. There are numerous possibilities. The point is that it is never a good situation – unless you had a short position, which points to incentives to create solvency rumors.
The bottom line is that even when a company is fundamentally solid, a collapse to a very low share price can lead to its demise if it remains low.
Consequences of Failing
The consequences of Fannie and Freddie becoming insolvent are huge. For 2008, consensus estimates expect 2.5 million foreclosures. The real estate correction is far from hitting a trough, but it threatens to mount a slow recovery for several reasons.
- Inventories are still much too high
- The number of actively searching home buyers is too low
Why might this be? Well, inventories are too high because builders are even more clueless about what is going on than Washington. These are individuals who analyze the market by focusing on comparables and monitoring inventories. What they are missing is an understanding of the true nature of the economy and credit crisis.
Perhaps if Washington hadn’t fudged the data, builders could respond to the recession in a timely manner and inventories wouldn’t be so high. The next variable is the lending institutions. Throughout this fallout in real estate, the Fed has been trying to stimulate banks to provide as many loans as possible, with of course a focus on prudent loan qualifications. But most of the banks are approving only those with the highest credit ratings.
What all of this means are fewer loan originations for Fannie and Freddie, or to be blunt, lower cash flows. And at the current foreclosure rate, it is likely the GSEs will be paying out huge claims for the mortgage debt they guaranteed.
In my opinion, without additional capital Fannie and Freddie won’t make it. With 70% of all new mortgages involving Fannie or Freddie in some way, failure of one or both would create a big problem that would spread throughout the globe. Thus there is no way Washington would allow them to collapse.
U.S. Bailouts: Socialism for Corporations
In my opinion, no company should ever be bailed out with taxpayer funds or by the Fed’s printing presses (which indirectly taxes Americans since it ultimately damages the dollar, leading to inflation). And certainly no industry should be bailed out.
If a bailout occurs, the industry should be nationalized. Otherwise, this will create a moral hazard, setting precedence for irresponsible behavior and excessive risk-taking activities, knowing that they can always get bailout if things don’t work out. This is precisely the precedent established for the automotive, airlines and now the financial industry. There’s no downside for them; only for taxpayers.
I say let all of the banks, mortgage companies, bond insurers, and Wall Street come together and figure out how they will handle it. It’s in their best interest to make sure they work together on the mess they made. And don’t forget, MBIA and Ambac are still facing major problems as well. These guys need to be put on notice that government bailouts of any kind are not in the cards.
Bailouts are inconsistent with a free market economy. All they represent is socialism for corporations. If these guys aren’t forced to find their own way out of this mess, it will create a moral hazard, which will allow the same mess to happen again in the future. In fact, according to the dictionary, one of the definitions of moral hazard states:
“The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.”
Well isn’t that exactly why we have the current mess? All of the players in the mortgage loop misled and in many cases lied about assets, liabilities, and credit capacity. And the lack of any punishment or real regulation, combined with the lure of money created an incentive to take unusual risks.
No new regulations or laws are going to prevent moral hazards in the future. They have tried that over and over. The only way to minimize moral hazard is to let the banks fend for themselves, even if they end up failing, and punish those who acted dishonestly, especially the guys at the top. This is the way a free market economy is supposed to work.
As we know, that won’t happen since the Federal Reserve is owned and operated by the mega-banks. And it’s unlikely those who are most deserving will see any prison time because this is America, land where big money sets you free.
It’s funny how so many republicans (and I’m a republican who won’t be voting for McCain) preach how America’s free market system is so great while denouncing government involvement at every opportunity. They label any type of government intervention as a socialist policy, so as to give it a bad name. Yet, most of them are so ignorant not to realize that America’s free market system is badly in need of repair.
There simply are some services that are best provided by the government such as Social Security, utilities, agriculture, and healthcare – the basic needs for survival. Virtually everything else is best suited by the free markets. When you allow for-profit corporations to control the distribution of necessities, they are going to gouge you for as much as they can because they know you have no choice but to pay.
When you are talking about something as vital as healthcare, quality will always take a backseat to profits. That is precisely why HMOs are coming off record profitability while America’s healthcare system is not even ranked in the top 30 by the World Health Organization.
As well, taxpayer fraud will be ramped since there is no real oversight or punishment. Do I need to cite examples of Pfizer, Bristol-Meyers, and many other drug makers bilking Medicare for billions in fraudulent charges, Healthsouth, Tenet Healthcare, PacifiCare, and others committing accounting fraud and ripping off Medicare.
How about former CEO United heath carving up a $1.6 BILLION stock options retirement package? The list goes on and on. But guess what. Not one single healthcare executive has ever gone to prison. When illegal activities are caught, the companies pay a fine and it’s back to business as usual.
Washington learned its lesson with the agriculture crisis seen after WWI. Ever since then, this industry has become increasingly subsidized and controlled by the government. Can you imagine how expensive food would be if there was no government control over agriculture?
Now, back to the GSEs. I continue with more excerpts:
I want you to stop and think for a minute about all of the fraudulent practices within the housing industry. From inflated appraisals alone, 10 to 15 percent of MBS securities or up to $1.5 trillion have been overvalued. Combine that with the lack of transparency, questionable risk exposure and fraudulent practices by executives at Fannie and Freddie, and you have a disaster ready to strike. Now combine that with over 10 million Americans holding interest-only and ARM mortgages, throw in a million or two job losses due to say the failure of Delta, Ford, General Motors, or some other large vulnerable company, and you could end up with a blowup in the MBS market. This scenario would devastate the stock, bond and real estate markets. Most likely, there would also be an even bigger mess in the swaps and derivatives markets.
Under normal conditions, anywhere from 25 to 30 percent of the U.S. economy is directly affected by the housing sector. However, due to exaggerated asset prices from the housing bubble, this share is significantly higher. Housing prices have up to two times the effect on consumer spending as they do on declines in stock prices. Consequently, if housing prices decline by 25 percent, the economic impact will be as if the stock market declined by 50 percent.
Housing prices are absolutely critical to the success of companies such as Lowe’s, Home Depot, and Sears. As well, most banks are closely tied to the health of the housing market because one way or another you can bet they have exposure to the MBS market. Many of the larger financial institutions have a much greater risk exposure with real estate derivative products. Most likely, it will take several years for the real estate washout to be completed. We can only hope that the MBS market doesn’t experience its first blow up since inception, but don’t bet on it.
Source: America’s Financial Apocalypse: How to Profit from the Next Great Depression
As you might suspect, the current problems faced by Fannie and Freddie aren’t surprising to me. If they aren’t able to raise adequate capital they’ll need a bailout or a buyout. Bankruptcy is not an option (unless you count a court-appointed conservatorship by the government, which would wipe out shareholders).
No matter what you want to call it, the effects will be the same – more pain to the financial industry and the dollar. But it won’t send with Indy, Fannie, Freddie or the rest of the financial industry. Most likely the automotive and airlines industries will also need a bailout – that is, unless some firm is foolish enough to buy them.
Sure, Cerberus bought Chrysler, but at fire sale prices, and prior to the current meltdown. In conclusion, based upon the continued washout taking place in the mortgage and banking industries, you would be advised to buy gold, oil, and foreign currencies.
As investors, you should consider the possibilities I have mentioned. Take a look at your portfolio. Is it positioned to take advantage of or avert the effects of America’s financial apocalypse?
As consumers, you had better start thinking about any cash you might have in some of those high-yield savings and money market accounts. Understand that some money market accounts have invested in CDOs and other junk linked to mortgage debt. Also understand that your bank could be the next IndyMac.
Copyright © 2008. Mike Stathis. All Rights Reserved.
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