Saturday, April 6, 2013

Hank P’s “Pinch” – The Fannie/Freddie Story


Former Treasury Secretary Hank Paulson has been coming out of the closet and doing some talking, He spoke on Bloomberg the other day, (Link). He was asked about the record profit of $17B at Fannie Mae in 2012. He said:


“Well, I read the Wall Street Journal and the Washington Post today, and I had to pinch myself. I could hardly believe what I was reading.”


It was Paulson who officially put Fannie and Freddie (F/F) into concervatorship. That was four and half long years ago. Paulson made a bunch of critical decisions in those chaotic months. From the very beginning I wondered why he did not take F/F into bankruptcy. It would have been cleaner that way. The Treasury Department had to assume the mortgage debts of F/F. If they had not, the lights would have gone off, and they would still be off today. So that was a no-brainer. But why did Paulson not take the opportunity to blow up the equity in F/F?

Optics, and the realities of the situation probably had some sway in the decision to take F/F into concervatorship, versus a chapter filing. A bankruptcy would have been messy. The courts would have been involved. Lots of lawyers representing 10s of thousand of people who lost money. It would have been a circus.

Paulson is a smart guy. He must have looked at the $7t of F/F paper and said, “The hit starts at 5%”. In his mind (and many others at the time) the estimated total F/F losses were in the $400-600b range. Hank knew that a number even remotely close to that loss would put the F/F shareholders into the waste bin of the pink sheets. So Hank kept F/F alive. The actual losses were a a more modest $160b.


As it turns out, Hank’s decision with F/F is going to cost the government a fair bit of money. In addition, it’s going to gum up the works for an easy transition to some new government owned mortgage finance entity during the remaining Obama years. That reality is going to piss off a whole bunch of liberals in Congress. There is a ton of money to be made or lost in this story. There is the potential for some drama – a Cyprus style raid on wealth is a potential outcome.


If there is any value in F/F, it’s in the preferred stock, not the common shares. Some form of restructuring would seem to be the most logical outcome to this thorny problem. If that is the case, then the preferred shareholders will be first in line to get any value that might be left on the F/F carcass. The market is bidding up the old preferreds as if they were gold. I believe they might be the best performing stocks over the past six months.

There are two types of preferreds, $25 and $50 par value. An example of the price action for one of the $50 Preferreds, the Fannie G:




Two “bench mark” issues are the $25 par value FNM Preferred S and FNM T. The S’s have had the highest daily turnover, (the volume is still is a trickle compared to listed shares). I follow the “T”s as it has proven to be a price leader. It trades rich to the other pref, and to my eyes, all the other pref (there are ~20 individual issues) chase the move of the preferred T.


Note: The “T’s were issued in 2008, just five months before the F/F SHTF. Hank Paulson forced this deal. He insisted that Fannie raise additional equity. The deal was brought to the street by a syndicate lead by Merrill. 92m shares ($2.3B) of swill was pushed out the door. A significant portion of the crap ended up on regional bank’s books. This trash paid one quarterly dividend, and then went deeply into the tank. This was an absolute stinker of a deal. Paulson knew F/F would hit the skids. In my book, Paulson sold this crap to widows and orphans, and he never looked back.



Based on Friday’s close of $4.81, all the other pref stocks are headed higher.



F/F biggest asset at this point are the prior losses. These show up as deferred tax assets. For a company that has no prospect of future earnings, deferred tax assets have zero value. But for a company like GE, deferred tax assets are kept on the books at 100% of par. If this treatment were permitted for F/F, they would be technically solvent.

The market has established a value for the F/F common and preferred shares of  approximately $5b. The current values of the preferreds are equal to:

- 18% of original par value for the $25 pref and 16% of the $50 pref.

- Approximately 30% of the past due and accrued dividends.

In other words, they’re trading cheap.


In theory, (and based on some upside assumptions) F/F could operate for another five years, and they could pay back all of the money that the US Treasury has been forced to provide. If F/F were left alone, the taxpayers would get their money back, plus a very big return. As the government nut gets paid back, the value of the residual public securities should rise. While this would be a very desirable result for shareholders, it would also be a disaster for some politicians. The majority of congress wants to see F/F shut down, and a new government owned operation established.

I see no legal way to achieve the desires of congress. As F/F are profitable today, it will not be easy for them to be dissolved in a way that does not result in some consideration for existing stakeholders. If congress were to try to do that, there would be big court challenges. – I don’t think  it’s possible to tank F/F any longer. If that were to happen, it would be a significant expropriation of private sector wealth – think Cyprus (Cubed).


To me, the oddest thing about this story is that it’s the taxpayers that are going to end up paying back the F/F bailout. The deferred tax assets allows F/F to avoid paying any income taxes on their record profits. The pretax = after tax, so F/F are generating huge amounts of cash. They will use the untaxed cash to pay back the Treasury. This outcome was not considered to be even a remote possibility four years ago.


This story is far from over. When congress figures out that they are screwed, and F/F are coming back to life, there will be an effort to challenge that outcome. One way to blow up the common and preferreds would be to establish a new  ‘tax’ on F/F. This charge would reflect the fact that F/F benefit from an implied guarantee of their liabilities. While some charge might be justified, this would be done with the sole purpose of destroying the public shareholders. A very hostile thing to do.


Notes: I’ve been involved with the busted Pref for years. I’m hanging on to them – I don’t think the story is over. My original investment thinking was not based on a resurgence of F/F, I thought that the pref had to get settled one way or the other. When Hank P. put F/F into concervatorship (versus bankruptcy) the opportunity for some upside presented itself. So thanks Hank!

Investing in busted preferreds that trade in the ‘Pinks’ is very speculative business. Especially when they are “story” stocks. I believe that substantial up-and-down moves will be the norm for the pref stock. There is at least one scenario that leads to a zero value. F/F was never a suitable investment for widows and orphans – it’s much less suitable today. For the average investor, this story is better avoided than played.










  1. First, Hank Paulson is one of the men who made the population realize how ethically compromised Goldman Sachs is. He may have evaded legal prosecution by reason of political cronyism — democrats can’t go after Paulson without locking up Franklin Raines and Tim Geithner and Jon Corzine as well (there are plenty of other republicans too). But outside the courts, no one is going to trust Paulson or Geithner or Corzine or Blankfein or Prince or Pandit or O’Neal or Mozillo or any of the others who looted millions for themselves while bankrupting the financial system.

    Anyone who ever trades financial markets knows: your word is your bond. If people think you can’t be trusted, you are done. That applies to the crooks at the EU / Cyprus, and it applies to the crooks in Washington DC / Federal Reserve. They evaded legal prosecution, but they will never be trusted again. Long term, that loss of trust is more costly than the ~$600 million fine paid by Goldman shareholders (not the crooks running Goldman).

    Second, handling this GSE scam is really a no brainer. Congress would be negligent not to impose a credit insurance fee on FNMA/FHLMC, just like banks have to pay for FDIC backing. Congress is desperate for more revenue and it would be impossible for a bailed out company to claim they haven’t been given extraordinary favorable treatment already.

    Make the credit insurance fees retroactive to 2008, and let the common shareholders waste their legal money trying to fight it. They may or may not overturn the retroactive part, at great expense. But going forward, they don’t have a legal leg to stand on. Credit insurance should have been imposed all along.

    And if we are being honest Bruce … FNMA / FHLMC are not even on going concerns without massive US Treasury credit backing. They either pay for the credit backing, or they still go toes up. More than 100% of their so-called profit is really a credit insurance subsidy from US taxpayers.

    Imagine if the GSEs were required by law to buy credit insurance on about $9 TRILLION worth of bonds, backed by underwater mortgages and underemployed mortgagees.

    Lets charge FNMA/FHLMC about 40bp per year … which if anything is quite generous. $9 Trillion times 0.004 = $36 billion in credit insurance fees…. or more than double the $17B *reported* profits of FNMA. All of FNMA’s accounting profits are immoral taxpayer subsidies, not earnings. Numerous studies within the government and Federal Reserve have confirmed that FNMA/FHLMC do not, and have never, passed the benefit of lower borrowing costs on to taxpayers / customers.

    Congress has to raise new revenue somewhere — the federal government is actuarily bankrupt already. Raise more taxes on citizens / voters … or start charging for credit insurance that should have been imposed all along. The GSEs do not pass the benefit of the subsidy to struggling mortgagees / aka voters. This is a no brainer for any member of Congress that wants to get re-elected.

    • “Second, handling this GSE scam is really a no brainer. Congress would be negligent not to impose a credit insurance fee on FNMA/FHLMC, just like banks have to pay for FDIC backing. Congress is desperate for more revenue and it would be impossible for a bailed out company to claim they haven’t been given extraordinary favorable treatment already”

      Congress has already imposed a fee on the GSE’s, it’s called “HUD”

      I don’t think anything is easy regarding the GSE’s.

      1) Raising their G-fees – or any other fee – would make mortgages more expensive, which runs contra to why they were created, and exist still, in the first place.
      2) The govt can’t assume them and their balance sheets.
      3) The govt can’t downsize them without also shrinking availability of 15 and 30 year fixed mortgages, in step.
      4) The govt can’t even require them to demand high quality paper w/o that impacting the housing market, like today.

      Nothing except the prevention of the kind of fraud that perpetrated their collapse in the first place – and was by no means their doing (remember, these are regulated entities. They didn’t do anything that wasn’t orchestrated by lisping Barney Frank and others), can be done. And even with that, the next housing collapse will still demand that taxpayers foot the bill. Not that taxpayers “footed” anything, actually. The Treasury just printed more $, as it was going to do anyway.

      Fannie has lasted 80 years for a good reason: The relationship works. It and Freddie get a free govt dime, and the govt dictates policy, insuring their goals for home ownership are met.

      • @anon:
        1) Raising their G-fees – or any other fee – would make mortgages more expensive, which runs contra to why they were created, and exist still, in the first place.
        2) The govt can’t assume them and their balance sheets.”

        Rubbish on all counts.

        1) FNMA/FHLMC does not pass the benefits of lower borrowing costs through to home buyers. Never has. This is perhaps the one item/issue that both Dems and Reps (and the Fed and FHA) all agree on. Not one research paper has found any indication that lower costs are passed through. Ergo, requiring these two nightmare GSEs to pass through the savings -OR- forcing them to pay credit insurance fees — either solution would be far more in keeping with “why they were created in the first place”

        2) BULLSHIT. These are called GSEs (government sponsored entities) for a reason… they are government sponsored. And if you know anything of their history … both FNMA and FHLMC were 100% part of the US government until Lyndon Johnson decided to float equity to conceal his massive spending deficits. The GSEs were part of the government before, and they can be again. The current shareholders are irrelevent — the GSEs are not viable without ongoing taxpayer support. Heads the shareholders can suck it, tails the GSEs go formally bankrupt and the bondholders end up owning the companies (aka the Fed would own most of them). Either way, the shareholders own something with a negative stand alone value

        3) Regarding mortgage availability… you are revealing your lack of knowledge on the MBS market. FNMA and FHLMC are not issuing new mortgages today (they are refi-ing some existing mortgages). The “new” mortgages, when and if available, are being issued by FHA (via GNMA).

        4) you seem to be under the delusion that lots of new mortgages are being underwritten today … from which I infer that you spend way too much time watching CNBC and not enough time in the real world. Most people cannot get a new mortgage today, not even from GSEs. They have re-tightened lending standards; back to requiring 20% down and proof of income where the monthly payment is no more than 30% of gross income. Few borrowers are able to meet either criteria, never mind both.

        FHA allows 5% down mortgages and has low income programs to certain borrowers (mostly veterans, but some others). That is why FHA is underwriting almost all new mortgages. Unlike FNMA/FHLMC, FHA is 100% part of the US government.

        @anon: “Fannie has lasted 80 years for a good reason: The relationship works. ”

        Here, you prove that you are on crack or stupid or both. FNMA hasn’t even existed that long (not as a stand alone entity). It was a small government program during the New Deal, and wasn’t even a stand alone entity within the government until the 1950s. They became independently capitalized in 1968 when LBJ ran the government into the red.

        And until lisping Barney Frank convinced Bill Clinton to stick Franklin Raines in as CEO of FNMA … FNMA mostly acted as a mortgage insurer. FNMA owned very few mortgages on their own balance sheet — they just collected credit insurance fees.

        Franklin Raines, who was a politician with zero banking knowledge / experience, turned FNMA into the largest MBS hedge fund in the world (not unlike what that stupid man now at the Fed is doing!).

        As a politician, Raines had no understanding of the interest rate risks involved. No idea how to deal with negative convexity — probably had no idea what that is. Auditors pointed out that FNMA had absolutely negligent risk management systems — FNMA had no clue what their zero vol BPV was, never mind OAS BPV. They were “working on developing something” — despite running a leveraged trading book into the trillions of dollars. Franklin Raines had turned FNMA into a mamoth sized very leveraged hedge fund without building *any* risk reporting systems. In addition, Raines engaged in rampant accounting fraud — for which he was later charged. Being a politician, he never served jail time.

        Meanwhile then Treasury Secretary John Snow tried to point out the catastrophic risks that FNMA (and FHLMC) were running. None of the Wall Street banks were able to sell gamma at anywhere near the size FNMA would need to survive a big interest rate move up OR down. Any big move in interest rates, up or down, would doom FNMA even if there were no credit defaults.

        That is about the time that lisp talking Barney Frank went on the floor of Congress and lied his ass off in what has become a very popular youtube video. For political reasons, Obama was dumb enough to allow Frank and Chris Dodd (who was busy running interference for AIG and Countrywide and IndyMac) to co-author the joke known as Dodd-Frank Banking reform act. Imagine having Enron’s Ken Lay and Jeff Skilling co-author an accounting reform act and you have an idea of how stupid the Dodd-Frank act is.

        FNMA is not viable as is. It didn’t work for 80 years, or even 50. And the more that corrupt members of Congress get involved, the more imbalanced the thing gets. FNMA requires on going subsidies just to stay open; they still have very little risk controls; and they do not pass along lower borrowing costs to taxpayers / borrowers. In short, FNMA is like most government programs: it doesn’t do what it was supposedly created to do.

        But my guess is that other over-levered hedge fund … better known as the US Federal Reserve … will be the next thing to “suddenly” discover they don’t have proper understanding of the risks on their trading books. An academic idiot who wasn’t even qualified to mis-manage LTCM hedge fund is now playing hedge fund manager on over $3 trillion in bonds he doesn’t understand.

        Queue the Lisping liar from Massachussets to tell us how the Fed can do no wrong, and people who depend on interest income from their savings (eg the AARP membership) will not end up screwed just before their grandchildren get handed a bill for $100 trillion for a government that is too corrupt to care.

        In the meantime Anonymous, please stop babbling your political beliefs and try to learn how the MBS market actually *worked* (BTW — it isn’t working right now).

        • Nice tirade, but it doesn’t really address my point.

          “Congress has already imposed a fee on the GSE’s, it’s called “HUD””

          That’s really the point, sorry if you don’t get it. It defines why the GSE’s exist today and will tomorrow. Everything else is just verbal vomit.

  2. Bruce, Fannie and Freddie both signed an agreement with Treasury last August. All profits beyond a certain amount are returned to Treasury. Fannie and Freddie profitability is brought about substantially by Fed QE3.

    This will be interesting to watch.

    • While QE3 definitely helps, a lot of the “profit”s actually come from tax loss carry forwards (largely gone now), and from not having to pay market price for credit insurance / explicit US Treasury backing. The bulk is actually from borrowing money at Treasury rates (roughly zero) while collecting about 4% coupons on outstanding mortgages. Borrow at zero from the Treasury, lend to home borrowers at 4% (assuming everyone is paying their mortgage). Use a lot of the profits to cover credit losses, pass the rest back to the Treasury.

      At least at the moment, ALL “profits” are returned to the Treasury — the part that isn’t (on paper) returned to the Treasury is the part being used to pay back loans from the Treasury. Two accounting entries, but basically all the reported profits end up at Treasury.

  3. Bruce, be aware that all the junior preferreds are non-cumulative; nothing is accruing. Other then that and pretty much all of them selling at 16% face, thank you for the shout-out.

  4. Barrons had a write-up on this very topic in the March 23 issue:


    Executive Summary: stay away from FNMA stock. As long as the government owns it, Treasury will continue to take the profits. if the government privatizes FNMA again, the new shareholders have no reason to give any part of it to the ex-shareholders (common or preferred).

    Many Democrat party congress members want to use FNMA as a tool to help low income borrowers get loans that no sane person would ever make. That means FNMA would forever operate at a loss — making existing shares worth even less than negative.

    And as Rabbit points out, nothing is accruing on the preferreds. Best case scenario, the preferreds are a lottery ticket that a bankrupt Congress is going to give former FNMA owners a windfall. Seems like Congress would buy more votes giving a windfall to underwater borrowers (which is still a long shot, but more likely than giving ex-shareholders a windfall)

    • “Executive Summary: stay away from, FNMA stock. As long as the government owns it, Treasury will continue to take the profits”

      They don’t own own it, they stole it.

      If someone – anyone – would forward me the precedent for such an action I would greatly appreciate it. Until then I consider my shares money good.

      • Obvious legal precedent: Continental Illinois Bank

        Like FNMA, Continental was hopelessly bankrupt. The government seized the bank, provided debtor in possession financing, made sure depositors were made whole, and sold off/liquidated what was left.

        More precedents? Thousands of former Savings and Loan banks (the S&L fiasco). The S&Ls were seized, depositors made whole (eventually … FSLIC was bankrupt too). The remaining assets were put into a separate government backed legal entity (Resolution Funding Corp) to be wound down over time (to pay off REFCO strip bonds)

        Seizing a company with taxpayer funds and then allowing shareholders to still own the company is a Hank Paulson thing — it is not obvious he had legal authority to do so. Good luck opening that can of worms.

        When FNMA and FHLMC went bankrupt, your shares became worthless. You are betting on a bunch of politicians being incredibly generous to ex-shareholders, while screwing home-squatters who vote. Those are some low odds with no legal precedent.

      • And I should mention that, even in the Hank Paulson cases, the former shareholders ended up with a much smaller share of whatever company. And to be more accurate, it is much smaller share of a company worth substantially less.

        I can’t think of any legal precedent for prosecuting a Treasury Secretary for actions committed while in office — not even when a secretary acted beyond his authority. Officially, the President is supposed to be the first check and balance. Congress is supposed to be a second check, but they are limited by the whole separation of powers in the Constitution.

        Even if you could somehow prove that Hank Paulson, while serving as Treasury Secretary, “stole” your company, and if you could prove that it wasn’t already insolvent (which it was) … you have no legal recourse. I am not trying to defend his behavior (which I think was legal, but immoral) — just saying there are no legal grounds for you to do anything about it. Ditto Bob Rubin’s interventions in Mexico with foreign exchange stability funds. Ditto with Tim Geithner for a very very long list of legal but unethical actions.

        AIG’s former CEO Maurice Greenberg is suing the US government over his lost ownership in AIG … but so far he only succeeded in angering a lot of taxpayers who bailed out the company against their wishes…

        That brings up the other legal issue in any attempt to pretend ex-shareholders of FNMA have a ownership stake: taxpayers were forced (involuntary) to bail out the company. It is not obvious the Treasury Secretary had the legal authority to do that either … but it obviously provided enormous benefits. Specifically, FNMA avoided a panic liquidation that would clearly have ruined shareholders.

        Compensating taxpayers for the cost of the bailout would easily wipe out any interest ex-shareholders had (note the past tense).

  5. “Like FNMA, Continental was hopelessly bankrupt.”

    FNMA is not hopelessly bankrupt. In fact, it made $17b last year.

    I recognize that 4 years ago the GSE’s were losing money and posed systemic risks, but that really is immaterial. And the same can be said for the TBTF’s, BTW. What is material is that they were put in conservatorship for the purpose to “preserve and conserve our assets and property, and put the company in a sound and solvent condition”, which they now are today. The govt had options back then. They could have treated Fannie as a bank and put it in receivership. They could have put us in chap 11 like GM. But they didn’t do either. They were so convinced the GSE’s would never be going concerns again, they screwed up.

    So, because today is not 4 years ago, what is the precedent for the treasury to simply “take” a going concern private company?

    • FNMA reported $17B in accounting profits, then you subtract out the credit insurance subsidy and the Fed yield curve subsidy, and the tax loss carry forwards … and if you were not talking your trading book, you would admit that the reported profits are completely fictitious

      Since you are just talking your book… you want to believe, and you look for evidence that supports your pre-existing beliefs while ignoring evidence to the contrary. Psychologists call it behavioral biases.

      The company was bankrupt, and is bankrupt. “they” (better known as Paulson and Geithner) did not put it into formal bankruptcy because of FNMA’s extensive political connections. FNMA still spends millions lobbying Congress — which means certain Congress members depend on FNMA for bribes. Paulson and Geithner are both ethically challenged people, and it takes a crook to know a crook — in this case the crooks in Treasury understood that crooks in Congress would fight attempts to bail out Goldman and friends unless there were also some kickbacks for Congress. Goldman money was laundered through AIG, and Congressional money was laundered through FNMA.

      That’s the corruption that runs the country now. The same corruption that made Paulson seize your worthless company is the same corruption that needed bribes / lobbying money from your worthless company.

      Politics explains why FNMA didn’t go chapter 7. But it was and still is bankrupt.

      • “FNMA reported $17B in accounting profits, then you subtract out the credit insurance subsidy and the Fed yield curve subsidy, and the tax loss carry forwards … and if you were not talking your trading book, you would admit that the reported profits are completely fictitious”

        Not sure what you’re trying to say there. FNMA made $17b last year via interest income and fees. DeMarco hasn’t allowed a claim on DTA’s yet. I should write Mayopoulos about not doing a better job bribing him. Ha!

        • Greg's secretary says:

          Greg: “talking your trading book, you would admit that the reported profits are completely fictitious””

          @rabbit: “Not sure what you’re trying to say there…”

          Answer —> “…the reported profits are completely fictitious”

          For those of you still talking your book, what I am trying to say is “…the reported profits are completely fictitious”. Fictitious. Make believe. Pretend. Not real. Existing only in ones imagination. I assumed that you understood what the word fictitious means.

          Enron reported lots of profits too. So did Govt Motors for many years. How many times has GM (really UAW) been bailed out in the last 40 years? Each time, the politicians tell the public that GM has been reborn and is a viable entity once again … until it runs out of bailout money and needs another bailout anyway.

          • Truth, although you could extend that cynicism to any company, actually. BRK is just one well placed nuclear warhead away from fictitious profits as well.

            Now go make me a sammich!

  6. How come you haven’t blogged on the BOJ? I am getting restless in anticipation.

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  9. What about the Gov’t “Community reinvestment act”that strong armed banks into giving loans to people the banks knew would never repay,but didnt care since,fannie fredie garranted the loans.

    • Silly, with the GSE’s out of the way, the govt will just ask JPM to accept that paper instead. Nicely, of course. Like, on their knees…… while being dragged out by security.

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