STOCK MARKET WATCH -- Thursday, 30 August 2012

[Demeter]

1. Fannie Mae and Freddie Mac: Back to black

http://www.economist.com/node/21560886

The Treasury squashes hopes that the agencies may ever be private again...SINCE 2008 Fannie Mae and Freddie Mac, America’s two housing-finance giants, have been on life support, spared from insolvency by an intravenous drip of taxpayer cash. Lately, however, the companies have shown signs of life: earlier this month both reported their biggest profits since being forced into “conservatorship” four years ago.



That has sent a frisson through investors clutching preferred shares issued back when the companies minted money by using their quasi-governmental status to borrow cheap and buy or guarantee most residential mortgages in America. Between March and early August, many of Fannie’s old preferred shares, which now trade over the counter, jumped from around $1.50 to more than $3 (still a fraction of their $25 par value).

Several factors explain the turn in the companies’ fortunes. As home prices have stabilised, unemployment has gradually declined and troubled loans have been restructured or written off, the two have set aside ever smaller provisions for loan losses. In the second quarter Fannie reversed some prior provisions, adding $3 billion to the bottom line. More importantly, mortgages issued after 2008 now make up more than half of the companies’ portfolios. Thanks to stricter underwriting terms and slowing home-price falls, those mortgages sport far lower loan-to-value ratios and delinquency rates than “legacy” mortgages issued during the bubble years of 2005-08. As a result, both companies are firmly back in the black. Fannie recorded a $7.8 billion profit in the first half of this year, compared with a loss of $16.9 billion in all of 2011. Her sibling earned $3.6 billion, against a loss of $5.3 billion.

Under the terms of the original bail-out, the Treasury invested just enough each quarter in senior preferred shares to cover the companies’ losses and to keep their net worth above zero. In return the companies pay the Treasury a 10% dividend on those shares. Perversely, to distribute those dividends both companies have routinely had to draw even more cash from the government. But in the second quarter, neither had to. That has begun to bring down the net cost of the bail-out, from a peak of $151 billion at the end of 2011 to $142 billion now. A decade from now, the administration reckons the tally will be just $28 billion...The good news had one unwelcome side-effect, however. With profits now exceeding their dividends, the companies’ net worth began to grow, arousing hope that one day dividends might resume on their old shares. On August 17th the Treasury drove a stake through those hopes, announcing that rather than pay a 10% dividend, the companies would henceforth simply send every penny of profit its way. For those who did not get the message, the Treasury rammed it home: the move underlined that they “will not be allowed to retain profits, rebuild capital, and return to the market in their prior form.” Fannie’s old preferred shares promptly sank back to about $1.

While the companies’ status as public utilities now appears crystal clear, the federal government’s long-term role in housing finance is as muddy as ever. In the short run, it is indispensable. Fannie, Freddie and the Federal Housing Administration, another government agency, currently back some 90% of newly originated mortgages. In the long run, Democrats and Republicans agree that Fannie and Freddie should be wound down, but concur on little else. The Obama administration has proposed several options for a smaller federal role in backstopping mortgages: the companies’ regulator is exploring how to draw private insurers into the mortgage market via loss-sharing arrangements with Fannie and Freddie. Mitt Romney and congressional Republicans want to wind both companies down, but have not specified any remaining role for government. As with every policy of consequence in America, the fate of Fannie and Freddie must await the election.