On Sept. 7, 2006, NYU economics professor Nouriel Roubini stood before a group of econ geeks and made some bold predictions about the future of credit markets. One of those predictions -- which was likely met with a few chuckles and sneers, and perhaps some sympathy applause -- was that Freddie Mac
Oh, how right he was.
Two years later to the day, Freddie and Fannie -- created by the government to provide liquidity to the mortgage market -- have been essentially taken over by the government to, well, provide liquidity to the mortgage market. The ironies abound.
What's all this mean for shareholders? I don't need to remind you that common shareholders drew the short straw of the deal -- shares of both companies are down around 80% as I write this. "But why?" I've heard many people ask. "The government didn't wipe out the shares, as many predicted, so we're out of the woods, right?"
The Treasury's deal didn't necessarily "wipe" shares out -- they're still trading -- but shareholders might have a tough time distinguishing between the two. Three terms of the deal leave common shareholders with little more than scraps of hope:
- All dividends and voting rights have been stripped, for the time being.
- The Treasury gets warrants to purchase 79.9% of the companies.
- Common shares are now first in line for losses, last in line for profits.
These developments aren't bad. You'd have to cover them in sugar and wrap them in a bow to consider them "bad." They're downright terrible.
Most investors are focused on the second part -- the massive share dilution. Shareholders perked up yesterday when Reuters reported that "the government has no plans to exercise those warrants," but at the end of the day, it doesn't really matter. Warrants have to be carried on companies' books as fully diluting shares, so dilution essentially takes place regardless of the Treasury's desire to exercise them.
And if the Treasury didn't exercise them, what would that tell you? That common shares would be fundamentally worthless. The only situation where the Treasury would exercise the warrants is if shares held legitimate value. Hence, you get two outcomes: Either shares become worthless, or the Treasury actually exercises the warrants, and legitimate dilution takes place. Any way it gets spun, common shareholders are worse off than they were last week.
And keep in mind, this weekend's actions represent the first of what could be many moves. As time goes on and the housing market continues to wallow, it's entirely likely that Fred and Fan will require more capital injections, which would likely mean more dilution. Is it possible shares will be diluted to zero? Absolutely.
Going forward, many banks will benefit from this weekend's bailout. Annaly Capital
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