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As the dust settles on the first stage of the rescue of Fannie Mae (NYSE: FNM ) and Freddie Mac (we'll call them F&F), it's time to chalk up winners and losers. Which column(s) are you in?
Winners: U.S. taxpayers
Taxpayers are winners?! What did we win -- the right to backstop more than $5 trillion in obligations? The fact is we were already backstopping them; it just wasn't acknowledged. The fundamental difference post-bailout is that F&F's balance sheet will now be managed with taxpayers' interests in mind, rather than solely to maximize shareholder returns.
The bailout isn't the problem; it's a result of the tacit suicide pact that bound F&F and the government. Taxpayers are better off now because we are no longer implicitly subsidizing F&F shareholders.
Fannie and Freddie shorts
Not much to add here -- the shorts shot the lights out on this one. They include tireless finance wunderkind Bill Ackman, who adds Fannie and Freddie to his collection of scalps.
Losers: Shareholder-owned, government-sponsored entities
The government's rescue is a tragic, but predictable conclusion to a failed experiment in public/private stewardship. That's right; it was predictable -- and not just in hindsight.
It might surprise you to learn, for example, that F&F's straits are not entirely without precedent. Back in 1981, a sharp rise in interest rates left Fannie Mae insolvent on a mark-to-market basis (i.e., using market prices, the enterprise's liabilities exceeded its assets).
Fannie was able to continue borrowing in the debt market, albeit at higher rates; however, without implied support from the federal government, it's unlikely it would have survived. Between June 1980 and October 1981, Fannie's shares fell by almost two-thirds to $4.70 (price not adjusted for splits).
People have been sounding alarm bells about the risks F&F posed to the financial system for many years; the American Enterprise Institute, for example, published a book in 2001 titled Serving Two Masters, Yet Out of Control: Fannie Mae and Freddie Mac.
Alas, these warnings fell on ears deafened by the lobbyist's song. F&F deflected criticism and blocked attempts at proper oversight through lavish use of lobbying funds; the mortgage giants have long been recognized as virtuoso players in the Washington influence game.
For years, F&F shareholders were part-owners of a goose laying golden eggs. Through greed and incompetence, management finally managed to kill the goose. After reaping excess profits that were subsidized by taxpayers for many years, it's not unfair that shareholders should be mostly or wholly wiped out. There is no free lunch for them after all.
Bill Miller's Value Trust fund and affiliated accounts were Freddie Mac's largest shareholders. The bailout deals another blow to this value investor's reputation. Miller is a brilliant guy, one of my favorite thinkers on investing, but he appears to have completely misread the tone of the credit crisis.
In July, Miller's Legg Mason Capital Management and its affiliates increased their position in Freddie Mac to nearly 80 million shares. It was a disastrous bet, following failed investments in Countrywide Financial (acquired by Bank of America (NYSE: BAC ) ) and Bear Stearns (acquired by JPMorgan Chase (NYSE: JPM ) ).
They include Wells Fargo (NYSE: WFC ) and JPMorgan Chase. Wells Fargo owns F&F preferred shares valued at $480 million on its balance sheet; these are now trading at between 5 and 10 cents on the dollar. JPMorgan Chase owns $1.2 billion of these securities; by one analyst's estimate, a total loss could wipe out about half the bank's third-quarter earnings.
Both banks can easily absorb such losses, but the loss in value on F&F preferreds threatens the stability of some smaller lenders that are relatively more exposed to them. Among these are Sovereign Bancorp (NYSE: SOV ) and Gateway Financial.
Jury's still out: Investment banks
The government's implicit backing gave F&F a significant competitive advantage over investment banks like Goldman Sachs (NYSE: GS ) and Lehman Brothers (NYSE: LEH ) in the mortgage finance market. The perception that the government stood behind F&F's debt allowed F&F to obtain cheaper funding than their competitors.
Now that F&F have fallen from grace, you might assume that this would automatically leave the investment banks better off. All other things equal, that would be true, but the banks have their own problems at the moment. Post-crisis, the government could create a new regulatory framework that would curtail the profitability of the mortgage finance business.
Mortgage rates have decreased in the wake of the rescue -- so much the better for those who are house-hunting right now.
Through the implicit guarantee, F&F is an inefficient mechanism for taxpayers to subsidize homeownership. We won't know the long-term effect of the bailout for homebuyers until the government decides the ultimate fate of the two institutions.
Treasury Secretary Hank Paulson
A former Goldman Sachs CEO, Hank Paulson recently said in an interview: "Government intervention is not something that I came here wanting to espouse." Nonetheless, the rescue of F&F will define his legacy at the Treasury.
I won't entertain any conspiracy theories here -- Paulson didn't bail out F&F to help "his buddies on Wall Street" (as I have seen written). He did it because he happened to be in a position of responsibility when the situation blew up. One can argue about the finer points of the bailout's structure, but Paulson had his back against the wall -- non-intervention was no longer an option.
Even if you lost money on Fannie or Freddie, you can still come away a winner; chalk it up to experience and look for lessons in this debacle. For example, if you come across an investment that looks like "free money," you need to ask yourself: Who is ultimately underwriting it and under what circumstances will they turn off the spigot?
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