The government's Sept. 7 bailout of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) will add much-needed liquidity to the secondary market for U.S. mortgages. But it does little to resolve some bigger problems: excessive housing inventories, home prices that continue to drop, and the likelihood of mounting defaults and foreclosures as the economy worsens, say market analysts.
The Treasury Dept., by signing contracts with the government-sponsored enterprises (GSEs) under which it agreed to buy $1 billion of what are being called super-preferred shares, effectively wiped out the remaining value in existing common and preferred shares. The deal calls for the suspension of the dividends being paid to preferred and common shareholders in order to conserve cash while the companies are being run by their regulator, the Federal Housing Finance Administration (FHFA).
With the GSE rescue now a fait accompli, BusinessWeek decided to update its pre-bailout damage report on Fannie and Freddie to account for the Treasury's announced plan.
With roughly $35 billion worth of agency preferred shares in the market, the losses to investors will be substantial.
Gerard Cassidy, senior equity analyst at RBC Capital Markets who covers regional banks, expects the banking industry to collectively write down $25 billion to $30 billion on their balance sheets for losses on the preferred shares they are holding. "There's no way these banks are going to carry this stuff for more than the market price past September," he says.
Cassidy sees the total losses on the GSE preferreds as very straightforward, roughly 85% of the value on the banks' balance sheets at the end of the June quarter, before the GSEs plummeted in the wake of the Treasury Dept.'s expanded authority to engineer a bailout if necessary.
The intervention has resolved any lingering questions about both agencies' senior and subordinated debt, giving them essentially the same guarantee as U.S. Treasury bonds. And Treasury Secretary Henry Paulson promised to provide as much as $200 billion to Fannie and Freddie if necessary to deal with mounting losses due to mortgage defaults. But the bailout does nothing to bolster confidence in the private-label mortgage-backed securities languishing on the balance sheets of Lehman Brothers Holdings (LEH) and other large investment banks, strategists say.
The biggest hit to preferred shareholders is the loss of the dividend, which is the key reason to hold these shares given how little they tend to appreciates, Marilyn Cohen wrote in her newsletter. Tax Advantaged Investor, on Sept. 7. The elimination of the dividend — the primary reason for the plunge in preferred prices — will impair the Tier 1 capital of the regional banks that hold so many of the preferred shares, she wrote. And since many of these banks aren't meeting minimum federal capital guidelines, Cohen said she expects the Federal Deposit Insurance Corp. (FDIC) to seize additional banks that are having difficulty raising the capital needed to stay solvent.
Freddie Mac's series Z preferred shares had plummeted to 2.50 on Sept. 9, down 81.6% from their closing price of 13.56 on Sept. 5.
Drain on Capital
It's inevitable that banks and other financial institutions that hold large amounts of GSE preferred shares will have to take substantial writedowns on these assets in the third quarter. There are 12 banks and thrifts that would lose 5% or more of tangible capital were they to take a 100% aftertax, mark-to-market adjustment on their GSE preferreds, according to a Sept. 8 research note by Keefe, Bruyette & Woods (KBW). Only three banks—Gateway Financial Holdings (GBTS), Midwest Banc Holdings (MBHI), and Cascade Financial (CASB)—would fall below "well-capitalized" regulatory capital ratio thresholds if they were to apply the adjustment to second-quarter capital levels, while just one bank, MBHI, would be below the required capital ratio level in the case of a 75% writedown, the note said. (KBW expects to receive or intends to seek compensation for investment banking services from all three banks within the next three months.)
Although only a handful of banks will see a meaningful reduction of their capital levels, the loss of value on the preferreds still takes more than $30 billion out of the banking system, which will mean that much less lending by banks, says Frederick Cannon, a bank analyst at KBW who wasn't one of the authors of the Sept. 8 report. A large, well capitalized bank like Wells Fargo (WFC), for example, will have $400 million less in capital because of losses on agency preferreds, but since banks are allowed to leverage their capital by 12 times, that would make nearly $5 billion worth of loans unavailable, he says. It's all but impossible for banks to replace that capital with other sources given the constraints in the capital markets, he adds.
To continue to own the GSEs common and preferred shares from now is "essentially an option on Fannie and Freddie emerging from conservatorship as private companies able to create value in excess of a government subsidy," says Cannon. The odds that those shares will ever be worth much are low since the agencies will first have to pay back the Treasury for the value of the government's explicit guarantee, says Cannon.