What's really happening at Fannie and Freddie

Can you imagine how serious the situation would be if the New Zealand government was considering nationalising ANZ National Bank? It's obviously not and I'm not suggesting it will have to, but it's worth raising this scenario to show what a mess the US financial system is in. Barron's has a simply excellent article on the predicament facing Fannie Mae and Freddie Mac, who between them guarantee or own US$5 trillion or 42% of all mortgages issued in the United States. This article predicts that the US government would essentially have to nationalise these behemoths in coming months, wiping out the value of existing shareholders shares and perhaps even wiping out those with preference shares. This article actually drove down their share prices by 22% and 25% respectively overnight. Here's the guts of what Barron's Jonathan R Laing is saying.

An insider in the Bush administration tells Barron's Fannie and Freddie are being jawboned by the Treasury Department and their new regulator, the Federal Housing Finance Agency (FHFA), to raise more equity. But government officials don't expect the agencies to succeed. For one thing, only a "capital raise" of US$10 billion or more apiece would have any credibility. Yet, what common-stock investors would advance that kind of money to entities that have market capitalizations of $8.5 billion (Fannie) and US$4 billion (Freddie), especially as the FHFA will use its new powers to boost dramatically the regulatory capital the GSEs (Government Sponsored Entities) must have in coming years? Just as disconcerting for prospective shareholders, all but US$300 million of the US$7.2 billion in equity Fannie raised in the second quarter was lost in the very same quarter, according to its fair-value balance sheet. With credit losses surging at both agencies, $20 billion in new common equity wouldn't last long. The balance sheets of both companies have been destroyed. On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of US$5.6 billion as of June 30, while Fannie's equity eroded to US$12.5 billion from a fair value of US$36 billion at the end of last year. That US$12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets. Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends.

Barron's is essentially saying that both companies are either insolvent or close to it if they are valued by the market value of their assets and liabilities. To put the size of this disaster into perspective, Fannie Mae and Freddie Mac guarantee 42% of all US mortgages, which are worth collectively around a third of annual US GDP. In New Zealand, ANZ National has NZ$54.95 billion worth of mortgages on its balance sheet, which represents 31% of our annual GDP. There are a couple of big differences. ANZ National is New Zealand's biggest bank as well as its biggest mortgage provider, so a financial drama for ANZ National would actually be much more serious for our payments system. America's mortgage lending and funding system is often run quite separately from the boring business of processing payments, taking deposits and making loans to businesses. In America, Fannie Mae and Freddie Mac buy and guarantee mortgages, but often have little connection with the end borrower. This is part of the problem. It does not do the sort of payments processing and regular banking that our banks do. American banks tend to much smaller relative (to the economy) than ours. They are often state or even county based, rather than national organisations. That is a legacy of rules set up in the wake of the bank failures during the depression of the 1930s to avoid banks getting to big to cause problems. New Zealand's banking system and mortgage system are the same thing and are much more concentrated and consolidated relative to the size of the total economy than in America. So the comparison doesn't bear much weight under examination, but it does show how serious the US financial crisis is and how far from over the Credit Crunch is.