The Bear Lesson for Fannie and Freddie

Treasury Secretary Paulson wants to be sure we all understand the lesson of overleveraging in a risk adverse credit market. Bear Stearns’ (BSC) shareholders must be taught the “moral hazard”. They must feel the pain. At the same time; Paulson is encouraging, if not totally imploring Fannie Mae (FNM) and Freddie Mac (FRE) to increase their leverage. Why should Fannie and Freddie throw caution to the wind when the Bear experience shows shareholders get virtually nothing in a bailout?

Reuters provides some interesting statistics. Freddie shrank its owned portfolio by an annualized 9.4% year to date and 12.4% in February alone. When combined with insured mortgage securities sold, their total portfolio actually increased 8.4% annualized year to date and 12% in February ($2.132T). Fannie’s owned portfolio increased just 1% annualized in February.

The GSAs regulator reduced their excess capital requirement from 30% to 20% last week. This would allow the companies to purchase $200B in new mortgages. Paulson is now strong arming them to raise an additional $10B in capital so they could “bailout” the financial system. Both companies have said in their conference calls that the high cost of capital favors guaranteeing over purchasing mortgages.

The companies also need to preserve capital to cover the increasing losses. Freddie portfolio losses jumped to 0.71% in January from 0.65% in December. In the new Paulson/Bernanke environment shareholders finish last, so management must resist any government pressures which endanger shareholders.

In my "Paul Volcker Concerned with Bernanke’s Fed" post, I spoke of Paul Volcker’s regret that the government sold Fannie and Freddie. But, given that it happened, the companies’ boards are required to protect shareholders. Unless the Treasury is willing to provide substantial cheap long-term capital, Fannie and Freddie should not expand their owned portfolios.

The much trumpeted implied government guarantee, if it exists, applies only to the GSAs debt. Here again, in a bailout the shareholders will finish last.

Disclosures: Author is long FNM and FRE.

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