THE inevitability of a taxpayer-funded bailout of Freddie Mac and Fannie Mae, the hobbled mortgage behemoths, shook investors last week, and shares in both companies plummeted on fears that existing stockholders would be wiped out.
These government-sponsored entities guarantee or hold $5.2 trillion in mortgages and have been hammered by defaults across the nation. Fannie Mae’s shares closed on Friday at $5, down from almost $70 a year ago. Freddie Mac fell to $2.61, which is down from about $65. Their heavily leveraged balance sheets magnify even a small rise in delinquencies.
There is no certainty about what form a Mac ’n’ Mae rescue would take. Naturally, this is giving investors the jitters. Up and down Fannie’s and Freddie’s capital structure, debt and equity holders want to know how a bailout would affect them.
It is widely assumed that debt issued by Fannie and Freddie will be backed by the taxpayers. Call it “too big to fail times two.”
But in our highly interconnected financial world, where one company’s ills have the potential to infect many others, no bailout exists in a vacuum. And the ripple effects that may result from shoring up these giants extend from the obvious — hammering their shareholders — to the fairly obscure, involving participants in the market for credit default swaps.
This is the huge arena where participants buy and sell insurance to protect against defaults by issuers of debt. Some $62 trillion of insurance has been written, with a fair value of $2 trillion at the end of 2007.
Back to the bailout du jour. Many analysts hypothesize that the Treasury will put cash into Fannie and Freddie, receiving dividend-paying preferred shares in return. Such an investment has occurred before, as noted last week by UBS research analysts in Mortgage Strategist, a weekly research report from the firm. In 1954, when the government began to change Fannie Mae into a shareholder-owned company, preferred stock was issued to Uncle Sam to help finance the process. Those shares were retired in 1968 when Fannie Mae became a publicly traded corporation.
If preferred shares are again issued in exchange for taxpayer cash, common stockholders could lose the most because new preferred shares would take precedence in the payment of dividends and if the companies were liquidated.
Investors holding the preferred stock already issued by Freddie and Fannie could also be vulnerable if the bailout puts the taxpayers’ investment ahead of them for dividend payments. Regional banks and savings and loans hold most of these shares; with these institutions already hurt by the mortgage mess, it seems unlikely that the Treasury would structure a Mac ’n’ Mae rescue in a manner that would pound them again.
But the potential effects of a rescue become more complex for the holders of Fannie’s and Freddie’s $19 billion in subordinated debt, so-called because it ranks below other bonds in the companies’ capital structures.
As UBS analysts point out, because Fannie’s and Freddie’s subordinated debt is used when they calculate capital — the financial cushion regulators require to support the companies’ operations — interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.
While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a “credit event.”
ON its Web site, and in language that only a lawyer could love, Fannie Mae describes some terms of its subordinated debt. For the debt to qualify for capital calculations, it must require the deferral of interest payments “for up to five years if (1) Fannie Mae’s core capital falls below minimum capital and, pursuant to Fannie Mae’s request, the secretary of the Treasury exercises discretionary authority to purchase the company’s obligations under Section 304(c) of the Fannie Mae Charter Act, or (2) Fannie Mae’s core capital falls below 125 percent of critical capital.”
Here’s a translation: A bailout could mean no interest payments on the subordinated debt.
