GSEs: Fear leads to suffering

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity. Even senior paper is 7-8bps wider on the day. MBS look to be only about 4bps wider.

I've heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he's been up to his eyeballs in 100 bond lots today. Haven't heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.

The catalyst was Barron's (followed by Barclays and Merrill Lynch) saying that a Treasury-backed infusion was only a matter of time, and that common shareholders would be wiped out. Barron's also suggested that preferred shareholders would lose their dividends. I doubt that very much, but more on that later.

The ultimate problem here is best described by Merrill Lynch's Ken Bruce. You can dive into Freddie Mac or Fannie Mae's balance sheet and make a good case that they don't need new capital, at least under current forecasts for housing. You'd therefore conclude that if they were a truly private company, they'd best serve shareholders by trying to stick it out. But they aren't a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs. The case will be made that the collective needs lower mortgage rates, and only a strong, liquid and publicly minded GSE can help bring that about.

And indeed, tax payers take the least risk the sooner action is taken. The more unsettled markets become, the harder it will be the stabilize. And the more unsettled things become, the more losses will be alread baked into the GSEs book. If the tax payer's position in FRE/FNM's capital structure is ahead of preferred shareholders and behind senior debt holders, the risk of the government actually losing money should be low. Where sub-note holders fall remains to be seen.

As for wiping out preferred shareholders... Remember that the big preferred shareholders are smaller banks. I don't think it would make sense for the Administration to bolster one part of the banking system (Fannie and Freddie) at the expense of another part of the banking system (regional banks). And besides, I don't think its necessary to protect tax-payers interests. With Treasury backing, the GSEs will have a luxury they don't currently have: time. Within 3-years or so, I'd expect FNM and FRE to both be profitable on a cash-flow basis. At that time the government can spin it off for a profit or fold it all into FHA.

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don't know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury's next move is.