In another note, and to illustrate this point, Sedacca points out that it is not just Freddie and Fannie. Besides Washington Mutual, mentioned above, “RF (Regions Financial) needs to raise $2 billion says Sanford Bernstein. Let’s see, what are their options? They can sell debt. The problem here is that you couldn’t sell debt if you wanted. The last reported trade in RF paper was 2 weeks ago nearly +700 to the 30 year or close to 12%. Their preferreds trade at 10% and the stock is now a ’single digit midget’ near $8 a share. So if you could even get a deal done, shareholders would get a 50% haircut.”

Fannie, Freddie, and the Credit Crisis

Let’s turn to Freddie and Fannie. There must be some people who think there is some way that the shareholders of Fannie and Freddie will not lose everything, as their shares actually trade. This just simply goes to show that you can fool some of the people some of the time. And as we will see, some of those people are very serious institutions.

It is almost a forgone conclusion that the US Treasury will have to step in and for all intents and purposes nationalize the two government-sponsored enterprises. The estimated losses in these two firms are far beyond what they could raise in a traditional market. And the longer the government waits, the worse the situation is likely to get.

Moody’s downgraded the preferred stock in these firms to almost junk level because of the increased likelihood of “direct support” from the US Treasury, which, depending on the nature of the support, could wipe out both the holders of the common and the preferred. The preferred shares have already lost half their value since June 30 on speculation that an intervention would mean a stop in dividend payments (highly likely) and issuance of new preferred that would take preference over current preferred.

Interestingly, this would put more pressure on the banking system, as many banks hold the GSE preferred shares as assets, choosing to get a little extra return over traditional and more conservative assets. But then of course, Fannie and Freddie preferred were considered safe just a few months ago, with the best ratings from Moody’s.

“Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million.” (Bloomberg)

It is doubtful that banks which hold these assets have written them down yet, but with a downgrade they will almost certainly be forced to do so in the near future. For the record, Fannie Mae has 17 classes of preferred stock, with more than 600 million shares outstanding. Freddie Mac has 24 classes of preferred stock, with about 460 million shares outstanding. The existing shares are trading worse than junk bonds, paying 17-19%.

And it may be a total write-off. It is hard to imagine how Treasury Secretary Paulson, or a new Treasury Secretary next year, could put US taxpayer money into the companies at risk without wiping out the current common and preferred shareholders. The justified outrage would be huge.

The basic problem is that without Freddie and Fannie the US mortgage market would go from crippled to moribund, if not dead. We have created a system that could not function in the short term without them, and the pain of allowing them to collapse would be another 1930s-style Depression, the era in which these firms were first created. They were never designed to take on the huge leverage they did, or to use hundreds of millions in lobbyist money and campaign contributions to create a massive payment scheme for management and shareholders. Congressional estimates are that this could cost US taxpayers $25 billion, a significant multiple of their current market caps.

Fannie and Freddie will not be able to raise capital on their own. At this point, why would any rational investor put that much money into a company with such a convoluted preferred share scheme, without government guarantees? That estimated loss assumes that the housing market does not get worse from this point. Losses could be much worse, or things could get better. Who knows? Why invest in something with so much uncertainty?

But there are more problems. You can’t just take someone else’s property, and that is what stock is, without some serious reasons. You almost are forced to wait for a crisis, otherwise shareholders would sue, saying that they suffered unnecessary losses. You can certainly expect the preferred shareholders to sue. That is why Paulson hired JP Morgan to figure out how to recapitalize the banks. I don’t envy the people who are working on that one. Maybe there is some magic somewhere, but as we saw with Bear Stearns, at the end of the day it is all about adequate capital.

The GSE companies should be adequately capitalized and broken up into much smaller firms that would not be too big too fail in the future, and put under a regulator that would enforce reasonable leverage limits, with the profits going to pay back the US taxpayer before any profits or dividends are paid to any other future owners.

That is, if the government takes the two GSEs and puts capital (probably in the form of loans and guarantees) into them, which puts taxpayers at risk, then allows a public offering of the smaller entities to raise capital to repay the loans, any shortfall should be made up by the issuance of preferred shares, and the common shareowners would wait until the government loan was repaid before they would be eligible for a dividend.

And the people responsible for creating the leveraged systems, the board, et al., should be forced to resign. New top management all around.

The ultimate goal should be for taxpayers to get their money back and any guarantee, implicit or explicit, to be removed. No mortgage bank should ever again be allowed to be too big too fail.

Now, taken as a part of the total credit crisis, which will run to over $1 trillion (at least), $25 billion may not seem like a lot. But I hope this is a wake-up call for better regulations and safeguards.

And before I go, let me reiterate my call for regulators to force banks to move their credit default swaps to an exchange. The potential for a blow-up is serious, and it could dwarf the current credit crisis. I am not saying it will happen, just that it could. Even a low-risk event should be protected against. Credit default swaps are legitimate business transactions. They are very useful. They should just be put on an exchange, like futures or options, where there is 100% transparency as to counterparty risk.

Baltimore, La Jolla, and South AfricaI am home for a few weeks, enjoying the tail end of summer. On September 6, Tiffani and I will head to Baltimore to be with Bill Bonner, founder of Agora Publishing, and a host of friends, to celebrate his 60^th birthday. It is hard to believe that we have known each other for 26 years. What an incredible business model he has created. He has adapted with the times, letting his business evolve into a multi-hundred-million-dollar enterprise. I remember first going to his offices in Baltimore, which were definitely in a very bad part of town. I was nervous just walking two blocks in broad daylight; but the offices were inexpensive, I suppose.

He is the one of the best pure writers I know. You can read some of his essays and subscribe to the free Daily Reckoning (be warned: Bill is quite bearish) by clicking on this link: http://www.dailyreckoning.com/rpt/mauldin.html.

Tiffani and I will then be going to La Jolla September 15 to meet with my partners at Altegris, and meet some new potential associates. Right now, drinks with Richard and Faye Russell is on the calendar, and I really look forward to it.

Then a few weeks later I will head off on a quick trip to South Africa, where I will be speaking for an investment group in Cape Town, then maybe stop off in London for a day and then hurry home in time to do my regular letter.

That is enough to make me tired, so I think I will hit the send button and go home and see who is there. Have a great week.

Your needing to seek my own balance analyst,

John Mauldin

Source: It’s More than Fannie and Freddie

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