Freddie Shareholders: There's Nothing Left

So what are you waiting for?

Morgan Housel
Morgan Housel
Aug 19, 2008 at 12:00AM

Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) fell 22.2% and 24.4% yesterday, respectively, unveiling some of the lowest share prices seen since the late '80s, when the average home cost around $90,000. In perhaps the saddest indication of just how pitiful these stocks are, Annaly Capital (NYSE:NLY) -- a small, scarcely followed REIT that purchases Fannie and Freddie securities -- now eclipses the market cap of both Freddie and Fannie. The customer, as they say, is always right.

Fueling the decline was a Barrons article highlighting the truth: There's literally nothing left for common shareholders, particularly for Freddie.

I'm not kidding
At last count, Freddie's shareholders lay claim to negative $5.6 billion in assets, based on mark-to-market accounting. If you missed it, that's negative. Now, as many financial firms have learned lately, mark-to-market accounting may be leaps and bounds from reality. Regardless, investors, regulators, and more importantly, the U.S. Treasury Department could give a flying Freddie about what management "thinks" assets are worth. Negative $5.6 billion. That's the investing equivalent of your doctor entering the room with his head down, clearing his throat, and asking you to have a seat.

Raise $5.5 billion of these and call me in the morning
Consequently, Freddie needs to raise capital. Few disagree on this, including CEO Richard Syron, who announced plans to raise $5.5 billion in capital in May. Unfortunately, waiting has its price: The capital has yet to be raised, and Freddie's stock sits more than 80% below where it was in May. Raising $5.5 billion at these prices will accomplish two things: Bring shareholders' equity to, well, zero, and dilute the pants off any hopes of a rebound.

That said, you would think the stock would now trade closer to zero -- pennies at best. For most companies, it would, but Fannie and Freddie have an implicit government guarantee floating around. That guarantee does wonders to keep these companies alive, but let's distinguish between two very different concepts: Guaranteeing the assets Fannie and Freddie own and insure, and guaranteeing the livelihood of common shareholders.

That's where the Barrons article comes back into play. What scared the dickens out of shareholders yesterday was the reminder that, in the case of government intervention, common shareholders will likely be decimated. As Barrons put it, "It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime ... Such a move almost certainly would wipe out existing holders of the agencies' common stock."

This makes a lot of sense. Freddie and Fannie are too big to fail, no doubt about it, but keeping them alive by no means has to include common shareholders. Barrons suggests that any recapitalization would come from preferred shares that would effectively wipe out anything common shareholders held onto.

This should sound sort of familiar. In Bear Stearns' fiercely debated bailout, the $29 billion chipped in by the government went to finance select assets, not into the pockets of shareholders. JPMorgan Chase (NYSE:JPM) took care of that part. In fact, it's possible all public money will be recovered, and the "bailout" won't cost tax payers a penny. That's how it should be.

By the way, we can't afford any of this to begin with
At a time when economic pain hovers around monstrous deficits, everyone knows these bailout programs have limitations. After all, the money to fund them comes from issuing debt ... the same reason companies are in such a pickle to begin with. As George Washington once said, "To contract new debts is not the way to pay old ones."

Besides, If Freddie and Fannie shareholders get bailed out, who's next? General Motors (NYSE:GM)? United Airlines (NYSE:UAUA)? Sallie Mae (NYSE:SLM)? The list could go on. When we're this close to an election, taxpayers are certain to stomp their feet at any attempt to prop up common shares. Privatize profits, nationalize losses? It just won't fly.

Put it all together, and Freddie shareholders seem destined for doom. Barring an astonishing real estate turnaround, there are two outcomes: Either the company remains on its current path, with negative equity and real estate in the throes of disaster, or (more likely) it gets intervention from Uncle Sam, in which case common shareholders get reminded of Aryabhata's greatest discovery: the concept of zero.

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