Friday, February 29, 2008

Sacrificing Fannie And Freddie

Adviser Soapbox
Andrew Horowitz, The Disciplined Investor

The Federal Reserve and the financial powers have thus far been classified as "creative" in their handling of the credit crisis.

During this week's testimony from Federal Reserve Chairman Bernanke, a news item flashed across the wire: The Office of Federal Housing Enterprise Oversight (OFHEO) will be relaxing some of its operating restrictions for Fannie Mae and Freddie Mac.

In particular, OFHEO said that it would remove caps on mortgage-portfolio growth and will gradually reduce its current requirement that both enterprises maintain capital reserves 30% above statutory minimums.

These capital requirements, initiated in 2004, are in place for good reason. Back then, it was found that these companies were not keeping their financial records in order while their executives were making millions.

This move, essentially, will allow for additional money and credit to flow into the economy, but the timing of the OFHEO announcement is, at best, suspicious and very worrisome. It comes too close to the discussion by the Fed regarding their understanding of the current housing problem and the additional problems that lie ahead.

Sure, there is clearly a need for additional capital directed toward consumers who are in a credit stranglehold. Yet this seems to be more of a desperate move--and a gamble on the future security of the credit markets. Remember, the reason why there were caps in the first place was that there was a significant breakdown in the way Freddie Mac and Fannie Mae were handling their financials. The penalty was a much greater capital requirement for each enterprise.

"Since agreements reached in early 2004, OFHEO has had an ongoing requirement on each enterprise to maintain a capital level at least 30% above the statutory minimum capital requirement, because of the financial and operational uncertainties associated with their past problems," writes OFHEO Director James B. Lockhart in a statement. "In retrospect, this OFHEO-directed capital requirement, coupled with their large preferred-stock offerings means that they are in a much better capital position to deal with today's difficult and volatile market conditions and their significant losses."

Excuse me, but a release of the cap will help to keep their problems in check? Surely there are different problems now--and the 30% cushion helps to keep the stability of the quasi-agency companies during times when write-offs and write-downs are growing. Think of this cushion as analogous to the loan-to-value minimum homeowners are required to meet to qualify for a mortgage.

One of the problems that helped to enhance the mess that we find ourselves in today was the lack of a belief that old-fashioned loan and risk management procedures were of no consequence. Bad assumptions were, and are, standard operating procedure and we now know that it was not the best way to operate.

So don't be upset when you see a continuation of massive losses at Fannie and Freddie. Rest assured they will continue to flow like a raging river for some time to come.

The fact that Moody's is looking into downgrading these names is one of the few murmurs of sanity in this situation. It is clear that companies in dire need of credit expansion (builders, retailers) may be acting on a last-ditch-effort approach that will have them spin positive on any plan--no matter how detrimental it will be to our national financial health.

Freddie Mac is also reporting the average current, adjusted loan-to-value ratio for its single-family home portfolio has been increasing steadily over the past few years. It's now 60%, up from a low of 56% in 2005.

Even so, Freddie Mac holds 16% of subprime adjustable-rate mortgages 90 days or more delinquent or now in foreclosure. This is a far greater percentage of these types of loans in trouble this soon than at any time over the past 10 years. ARMs are considered hybrid mortgages, and as this category currently makes up such a large portion of Freddie's portfolio, there is reason to be cautious.

As housing prices continue to decline, loan-to-value ratios will continue to suffer. This is just one more part of the larger concern that investors will have to ingest as they are asked to commit more funds in the form of debt and preferred stock offerings. In the face of a credit-rating panic, it will be interesting to see how they adjust their portfolio strategy to ensure that investors see the highest rating available in order to efficiently peddle their debt at the lowest cost.

Either way, FRE and FNM will surely have a higher cost of operations as they move forward. Everything points to lower net earnings and higher investor anxiety.

Chronic borrowers will be excited as there will, in theory, be more of the credit "drug" available to help get them deeper into their debt hole. But do not make the mistake as an investor that it may be time to jump in. This move will have a negative effect and eventually weaken FNM and FRE.

Simply using debt-to-equity ratios as a proxy for loan-to-value will show that this is more of a creative mechanism for credit to flow that will have the near-term effect of throwing these two companies under the bus. We continue to warn investors that this type of gamble may lead to further solvency issues rather than balance sheet stability for Fannie and Freddie.

Any downgrade (hard to fathom?) will also create a greater problem, as the cost for asset-backed credit will eventually be need to be paid b ... you and me! These will take the form of a tax burden that will be left to be cleaned up by the "winners" of the upcoming election.

The bottom line: Freddie and Fannie are being thrown under the bus in order to help the housing markets and in an effort to protect the credit markets. The removal of the mandatory cap is a dangerous gamble by regulators. In the end, there needs to be a sacrifice to save the rest of us. Freddie and Fannie may well be the burnt offerings to appease the credit gods.

Andrew Horowitz is founder of Horowitz & Company, a investment advisory business in Weston, Fla. He writes The Disciplined Investor blog, and is the author of a book by the same name.

No comments: