Fannie and Freddie Conservatorship Failing?

The Wall Street Journal “Mortgage Plan Isn't Cutting Rates” summarizes the track record of Fannie Mae (FNM) and Freddie Mac (FRE) since the 79.9% solution (conservatorship):

• The conforming 30-year fixed rate mortgage rate rose from 6.34% to 6.64%.
• GSE five year notes are selling for 1.5% over equivalent treasuries.
• GSEs are increasingly funding mortgages with short-term paper.
• Running a mismatched book requires the GSEs to increasingly depend on derivatives.
• Writing off tax credits will wipe out a substantial portion of the GSE’s capital.
• Decision making is slow because the regulator’s approval is required for anything of importance.
• Total investor confusion about the government’s guarantee of the GSE debt.

On the positive side, Fannie CEO Herbert Allison and Freddie CEO David Moffett both stated during last week’s mortgage banker’s conference that the GSEs must be fairly compensated for risk. This tells me that despite Treasury Secretary Paulson’s rhetoric about running the GSEs for the public benefit, Paulson wants the GSEs to be run as profitable and sound businesses.

The good news for GSE shareholders is that Paulson is minding his portfolio. We have a pattern developing of Paulson asking Congress for government money so that financial institutions can benefit consumers, then using the money to strengthen his portfolio. Paulson chooses only the financial institutions he sees providing a good return and acting as an activist investor to insure that it happens. The winners and losers have already been chosen, with the losers fed to the winners. Given this track record, the heavily diluted GSE shareholders might not be total losers after all.

Paulson is, however, failing in the delicate tightrope walk of the GSE debt government guarantee. The government does not actually guarantee any GSE debt, but will provide capital to the GSEs to prevent their negative net worth. Even Federal Housing Finance Agency (GSE regulator) Director James Lockhart was confused during Congressional testimony as to whether the government was granting an "explicit" or "effective" guarantee. Investors are not buying that GSE debt is equivalent to treasuries.

My understanding is that the GSEs will continue to file SEC quarterly reports. I can’t wait for the conference calls.

Disclosures: Author is long FNM and FRE.

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