Fannie & Freddie Bailout and Credit Default Swaps
I don’t have a stake in either of these companies, but the implication of a bailout will indeed have effects on the economy. A few well known value investors took the bait on them:
No question, this panic-state among financial stocks has resulted in current portfolio pain. However, history reminds us that extreme valuation opportunities occur in world-class franchises like Freddie and Fannie only when most investors have given up on them. In our own 12-year history we have taken advantage of this phenomenon many times; several of our portfolio holdings were outstanding businesses that we were able to purchase at a fraction of their fair value due to the conventional wisdom at the time.
Looking at this list we can recall the market sentiment surrounding each at their weakest points, and the characteristics are eerily similar to that surrounding the GSEs today; current bad news, uncertainty about the likely duration and depth of the bad news, management missteps, accounting shenanigans, and stronger / better competitors. It is precisely because investors tend to focus exclusively on the struggle of the moment that real analysis becomes the province of the very few daring to question the crowd. This commitment to analyze when everyone else has given up is the fundamental force that drives the excess long-term returns for value investors, and is why we believe Fannie Mae and Freddie Mac are extraordinary values.
FREDDIE MAC AND FANNIE MAE: A SPECIAL UPDATE (Pzena Investment Management)
Pzena states that extreme valuation opportunities occur when investors give up on them, but that really wasn’t the case here. The equity holders of FannieMae (NYSE:FNM) and FreddieMac (NYSE:FRE) were buying ownership of as Barack Obama likes to call it a “weird blend” of private and public entities. When you do that, you open yourself up to the risk of the government having to step in and bailout the company if things go wrong. When that happens, you (the equity holder) are not bailed out because they are not obligated to do so. Instead, their primary focus is only keeping these companies up and running and that was the real worst-case-scenario for their valuation, not fair book value but $0.
In the context of tough credit markets and a poor housing market, I’m unsure of how an investor could have really perceived a true margin of safety with either of these companies because of their relationship with the government. Still, there are conflicting views on what shareholders will get, according to Bloomberg:
Shareholder Fate
Washington-based Fannie and Freddie dropped in after-hours trading. Fannie fell $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70. Fannie is down about 66 percent since the end of June as concerns about the companies’ capital grew. Freddie has fallen about 69 percent.
Fannie’s market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie’s has fallen to $3.3 billion, from $22 billion over the same period.
The Washington Post reported that the government would make quarterly injections of funds as the companies’ losses warranted, avoiding a large up-front taxpayer cost, citing sources it didn’t name. Debt and preferred shares would be protected, and common stock would be diluted while not wiped out, the Post said.
The New York Times said most or all of both the common and preferred shares would be worth little or nothing.
One of the things I’m curious about is the effect of this on credit default swaps. My largest holding, Fairfax Financial (NYSE:FFH) owns credit default swaps on both Fannie and Freddie. I’ve been wondering about how this might turn out for those positions. According to the New York Times:
As UBS analysts point out, because Fannie’s and Freddie’s subordinated debt is used when they calculate capital — the financial cushion regulators require to support the companies’ operations — interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.
While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a “credit event.”
Because nonpayment of interest would be seen as a credit event, UBS added, entities that have bought protection on Fannie’s and Freddie’s subordinated debt would be entitled to payment by the entities that wrote the insurance. This, even though taxpayers are standing behind Fannie’s and Freddie’s debt, not allowing it to fail. Talk about the laws of unintended consequences.
However:
It is possible, of course, that a Mac ’n’ Mae bailout will be structured so as not to force credit default swap payouts. Or regulators could step in and require parties on both sides of the Fannie and Freddie credit insurance trade to unwind their stakes at heavily discounted levels. Such has been the nature of recent deals struck by financial guarantors like Ambac at the behest of the New York State Insurance Department. In one deal, the credit default swap buyer got just 13 cents on the dollar; in another deal, the buyer got 61 cents.
What Will Mac ’n’ Mae Cost You and Me? (NYTimes)
So it seems like until we get more details about the bailout plan, CDS holders will be left wondering about what happens. Hopefully that will come till monday. If anyone has a different view on how the CDS positions will be affected, feel free to comment.
Below is a cool chart I found in the bailout article:
Labels: Global Macro, Obama, Portfolio Updates
