Freddie Considers Hail Mary Pass: $10 Billion Stock Sale

It’s truly remarkable what a short squeeze and the threat of tighter governmental oversight can do. According to the Wall Street Journal, Freddie Mac is now considering raising $10 billion of equity to keep a government rescue at bay, or at least contained.

But what are we to make of this attempt at stagecraft? The full-bore push by Henry Paulson, with the hopes of getting a Fannie/Freddie rescue package of some sort in place by next week, have demonstrated loudly and clearly that the Administration perceives the two GSEs to be at risk. Their business model depends on their being able to finance at the very best terms. The issue isn’t whether they are at risk of failure (although Christopher Whalen argues that based on their leverage, they are below investment grade) but that paying spreads that reflect their stand-alone risk renders them ineffectual (not to mention it makes creditors who hoovered up their paper on the belief that the implicit guarantee meant something would be very unhappy to learn otherwise).

But Dick Syron at Freddie still wants to have his cake and eat it too. Not surprisingly, he prefers the GSE model of privatized gains and socialized losses, since we have now established that even an Administration wedded to the idea of “free market” will ride to the rescue of Freddie and Fannie.

Aside from the lucky break of a big rally in financial stocks, another factor no doubt played into Syron’s desire to see if he can get an equity offering off quickly. As a Wall Street Journal story, “Troubles May Diminish Fannie And Freddie’s Lobbying Clout,” tells us:

The financial troubles of Fannie Mae and Freddie Mac could diminish their legendary influence on Washington decision making as lawmakers prepare to put a tighter leash on the two mortgage giants.

The companies together have spent more than $170 million on lobbying since 1998, and their political action committees have given $1.5 million in campaign contributions to members of Congress in the 2008 election cycle.

As Congress debates a bill that envisions the tightest controls in a decade on Fannie and Freddie, the twin lenders have pumped more donations to influential lawmakers such as Republican House leader John Boehner, House Speaker Nancy Pelosi, and Senate Majority Leader Harry Reid….

Now, Fannie’s and Freddie’s troubles have weakened their arguments and enabled Congress and the White House, joined by fear of a deepening global crisis, to push what the lenders have fought hardest against — greater accountability to the Federal Reserve…

The Fannie/Freddie lobby machine is powered by the need to preserve perks that the lenders’ private bank competitors lack: tax exemptions, lower capital requirements and lower borrowing costs that spring from Fannie’s and Freddie’s hybrid status as government-sponsored enterprises. All these perks are potentially up for revision.

Although the results of successfully lobbying generally comes out of taxpayers’ hide somehow, I find it particularly galling that companies about to get the biggest Federal handout on record are spending what will ultimately be public money to cut a better deal for themselves.

Now to the main Wall Street Journal article, “Mortgage Giant Freddie Mac Considers Major Stock Sale“:

Mortgage giant Freddie Mac — emboldened by emergency regulatory actions that have triggered a two-day rebound in its battered stock — is considering raising capital by selling as much as $10 billion in new shares to investors, according to people familiar with the matter.

The high-stakes maneuver would have the potential to avoid a full-blown government rescue for Freddie Mac and Fannie Mae, twin keystones of the U.S. housing market…

Yves here. I would love to have been a fly on the wall when Paulson got word of this hare-brained scheme. As you will see, this deal is not likely to come off. But talk of it has the potential to muddy the negotiations with Congress considerably, which may be the real point of this exercise.

For its part, Freddie would like to avoid the stricter government oversight that could accompany any rescue. Its moves come as new details emerge about its recent stumbles…

A sale by Freddie of common and preferred stock could be tough to pull off. For starters, the preferred shares would require Freddie to offer a very high rate of return to attract buyers. The yield on one existing issue of Freddie’s preferred stock, for example, is about 13.8%.

At that rate, even a $5 billion preferred-stock offering would entail a $690 million annual payout, on top of the $272 million Freddie paid out on its existing preferred shares in the first quarter. That would reduce the money available to common-stock shareholders, cutting the value of those holdings and potentially sending the stock price lower.

The main buyers for any new-stock issues are likely to be existing shareholders world-wide, according to one person involved in the discussion, adding that a definitive plan hasn’t yet been determined.

In the short term, a sale of new shares might eliminate the need for the Treasury’s help, but a government bailout might still be required later….

Yves again. In other words, this is about Syron keeping his empire together as long as possible. No matter how much lipstick you try to put on this pig, there is no way you can pretend that it is a good idea to have current shareholders throw good money after bad (and the very notion that they are the targets for fundraising is an admission that no one else is dumb enough to be suckered in at this point).

In fact, one could argue that a fundraising now does Freddie shareholders a huge disservice. The Bush Administration is likely to extract as much from Congress as possible while minimizing oversight, since that minimizes culpability (in their fantasy world, anyhow), Raising new equity merely kicks the can into the next Administration, and if Obama wins, a Democratic president and a Congress with a larger Democratic majority are just about certain to impose tougher rules on the GSEs.

Back to the Journal:

Analysts expect that Freddie and Fannie both will face significant losses in the months ahead as the housing crisis shows no signs of slowing. …The two companies — which are rivals in the same business — have reported a combined $11 billion of losses over the past three quarters…

Investors and analysts can only guess how bad the losses might be as several million American homes go through foreclosure. Analysts at Goldman Sachs Group Inc. this week estimated that Fannie faces default-related losses of $32 billion and Freddie $21 billion. Those losses, expected to be mostly realized over the next few years, will be offset to some extent by growing revenues and higher fees the companies can now charge.

Note that the combined equity of the two GSEs is roughly $86 billion.

Freddie’s board met Thursday to review options for selling new shares. Freddie Mac Chief Executive Officer Richard Syron has huddled frequently with investment bankers from Morgan Stanley and Goldman Sachs Group Inc…. The proceeds of a sale are expected to be in the range of $5 billion to $10 billion, according to people close to the discussions.

One idea that has been raised is a “rights offering” of shares, in which existing shareholders get first dibs on the new stock. Freddie, for its part, says it has plenty of cash for now and has hinted that it could resort to eliminating its dividend, for savings of $650 million a year….

The push to court private investors, rather than accept government money, illustrates how much Freddie Mac wants to avoid the potential for additional government controls…

For instance, if loans or investments are made with government money, lawmakers are weighing provisions to prevent the two companies from paying dividends to shareholders or issuing big paychecks to their management, says Rep. Barney Frank (D., Mass.), chairman of the House Financial Services Committee. Government assistance could require Fannie and Freddie to consult the government “before it can even pay its water bill for the toilet,” Rep. Frank said in an interview. He supports what the Treasury has proposed, which is to provide money for the two companies if needed….

It’s unclear how shareholders would react to the plan. At least one shareholder, David Dreman, whose Dreman Value Management owns more than 10 million shares, says Freddie might benefit from waiting a month or so to do such an offering. “Yields may go down and prices could go up after the government’s initiatives kick in,” says Mr. Dreman. “There shouldn’t be such a rush to get to the party at this point.” Still, he says, it is good corporate governance to give existing shareholders first dibs….

As of March 31, Freddie had “core capital” — a measure of financial strength consisting of retained earnings and other items — totaling $38.3 billion. That works out to 1.8% of the $2.15 trillion of mortgages Freddie owned or guaranteed as of that date.

That’s low compared with the requirements placed on other financial institutions, such as banks. Indeed, if Freddie were a bank, it would need about $91 billion to be considered well-capitalized, says Karen Petrou, managing partner at research firm Federal Financial Analytics in Washington.

That estimate seems awfully light. $91 billion is less than two and a half times Freddie’s current level of equity. As Chris Whalen pointed out:

JP Morgan Chase or BAC, for example, have almost as much bank-level capital as the GSEs combined supporting one fifth of the commitments.

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  1. Anonymous

    In the third paragraph it should be Freddie and not Fannie.

    Sorry, nothing constructive from my comment, but I didn’t want to give your detractors any ammo.

  2. Doc Holiday

    We just played this same game with Ambac and MBIA, so what happens, Paulson declares that the ratings agencies are going to make Fannie a Triple AAA Five Star Hotel?

    This is retarded chaos at its very finest hour!

  3. Anonymous

    Not clear why Paulson would resist new private capital coming in; Treasury and the Fed have their teeth into oversight as much as they want now; what’s to lose for them?

    JPM has an entirely different risk weighting on its assets (higher on average); the capital comparison is not equitable

  4. Anonymous

    “wants to have his cake and eat it too”

    That’s better written as “wants to eat his cake and have it too.” The idea is that you want to eat your cake but not have it disappear into your stomach…you want to eat it but still have it…you want to eat your cake and have it too. ;)

  5. Anonymous

    People keep using bank capital ratios to assert the GSE’s are undercapitalized. I don’t know if the GSE’s are undercapitalized or not, but I do know that there is no reason for them to have the same capital ratios as banks, which take entirely different types of risks. The GSE’s take no interest rate risk, for on thing. And they have no depositors.

    Also, I don’t know why you would think Paulson, who has been urging the companies to raise capital for many months, would now think that raising private capital is a bad idea.

    Finally, when a dilutive capital raise is in the offing, it is only fair for existing shareholders to be given first dibs via a rights offering. You seem to believe that it would be better for the GSE’s to go find some private equity or sovereign fund and sell shares at a deep discount, thereby transferring value from existing shareholders to new ones.

    One feature of this credit crisis that has gone largely unnoticed is the extent to which existing shareholders are getting screwed during capital raises that transfer their ownership of the enterprise to someone else without giving the existing owners a right of first refusal.

  6. macndub

    a Democratic president and a Congress with a larger Democratic majority are just about certain to impose tougher rules on the GSEs.

    I don’t actually buy this. The GSEs have so many friends on the Hill. Dems seem to buy the “affordable housing” pile of steaming, uh, nonsense. The GOP loves anything with the stink of incompetence and corruption. So I don’t see a world in which Fannie and Freddie have a ready ear on the Hill, regardless of the administration that follows.

    I wish it were different, but the days of politicians making tough decisions seem to be well behind us.

    One feature of this credit crisis that has gone largely unnoticed is the extent to which existing shareholders are getting screwed during capital raises that transfer their ownership of the enterprise to someone else without giving the existing owners a right of first refusal.

    If the equity offering is at market; ie, a transaction between disinterested buyers and sellers, then it’s hard to make the argument that value is being transferred from one set of shareholders to another.

  7. Yves Smith

    Anon of 11:36 AM,

    Existing Freddie shareholders will be massively diluted. The damage to their existing holdings is not improved by offering them a priority in buying new shares. I see it as in invitation to throw good money after bad.

    As for the GSE not taking interest rate risk, that is incorrect. In fact, their derivatives hedging to manage their interest rate risk is so large scale (and procyclical) as to create systemic risk. This was a big worry of Greenspan’s until the GSE accounting scandals put a brake on their growth and had the GSEs for a bit losing share relative to the size of the total credit market.

  8. anon2

    Anon 11:36 is quite correct on the issue of rights issues. Non-rights issues typically require a deeper pricing discount than rights issues. Rights issues therefore reduce the amount of dilution in raising new equity compared to the alternative. Existing shareholders with rights therefore have some relative control over the degree to which they are diluted by new equity raises.

  9. Anonymous

    Their portfolios are very closely duration-matched. You can argue that this does not entirely eliminate interest rate risk, but you can not credibly argue that they are not vastly different from banks in this respect. When it comes to looking at capital ratios, it just makes no sense to compare GSE’s to banks.

    A rights offering in which a shareholder participates is no more dilutive than a share repurchase is accretive. Certainly if you think the company has intrinsic value below the share price, you would not participate, but you would also not own the stock in the first place. Existing holders think the company has intrinsic value equal to or greater than the share price. Simple math shows that a rights offering does not dilute the value of a particpants holdings. If you have a bank account with $100 in it, and you do a rights offering in which you force yourself to put $10 more in, are you diluted? You are only diluted if you sell a share of your bank account to someone else for less than par.

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