Do Fannie and Freddie need new capital or not? A strategic look at OFHEO's recent statement...

Recently, shares of Fannie Mae and Freddie Mac took severe hits. Freddie Mac took an 18% hit yesterday, and Fannie Mae a 16% decline, in New York Stock Exchange trading.

Why?

This was due to an analyst at Lehman Brothers who stated that the two mortgage giants may need to raise additinal capital to keep weathering the current credit crisis.

We then got a quick response today from the Office of Federal Housing Enterprise Oversight (OFHEO thereafter). James Lockhart, the director, went on the record as saying, "An accounting principle should not drive a capital decision by a regulator.". Essentially, he is saying that the change of an accounting rule shouldn't drive capital requirement changes at a lending institution. The Lehman analyst was basically saying that Fannie and Freddie would need to put more money in reserve to keep their loans afloat...that is, having another capital raising.

Here's a chart showing the immediate decline Notice how the shares dropped right after the Lehman analysts comments Monday morning (7/7/08), and then notice how they are struggling to increase after Lockhart's recent statement this morning, Tuesday (7/8/08).

But, isn't something odd here? Why would a government institution make direct comment on a company's stock performance?

Here's why.

Friday, June 27th, Senator Charles Schumer, a Democrat from New York, sent a letter to various federal lending institutions (amongwhich was OFHEO) stating IndyMac Bank "may have serious problems with its current loan holdings, and could face a failure if prescriptive measures are not taken quickly." See here for the full article. Here's the chart.

After the letter, regulators from the Fed came out and slammed the senator, asking him to please--shut up! See here for a good read. Basically, the belief is that Schumer, since he's on the board of the Federal Reserve and knows things not public, let the cat out of the bag in his letter. Interestingly enough, with hindsight being 20/20, Indymac Bank closed down all mortgage operations yesterday and fired more than 50% of it's workforce!

Back to Fannie and Freddie.

So, you see that there is this apparent veil of reality in government regulators ensuring the already-skittish John Q. Investor to keep his capital in these lending institutions. Indymac Bank already accused Schumer of essentially causing a bank run...however this is quickly debunked by looking at their YTD stock performance.

The OFHEO is simply trying to stave off a massive selloff of Fannie and Freddie shares. Will they be successful?

Let's take a look at the 'new accounting rule' that caused such concern with the analyst in the first place.

The 'new accounting rule' is simply a revision of the Financial Accounting Standards Board Rule #140. This revision would include eliminating the QSPE's! Why is this HUGE? For starters, what is a QSPE?

A QSPE is a 'qualified special purpose entity'. Examples of QSPE's are, you guessed it, Fannie Mae and Freddie Mac. Essentially, these companies are able to originate loans and move the assets off their balance sheets, which increases the return on equity and assets. This, in turn, makes investors like their stock due to the ROE and ROA ratios, which pushes the stock price up further and further.

Lehman analyst Bruce Harting also said in his July 7 note that the very size of the impact on Fannie and Freddie probably means they would be exempted from having to comply. "We think it's likely the GSEs will be granted an exemption because a literal interpretation of their minimum capital requirements would suggest that the GSEs would become significantly undercapitalized, and it would be very difficult for them to raise the capital needed," Harting said in his note. (A GSE is a "Government Sponsored Enterprise) Quote taken from this article.
Interesting. Here's the logic. You don't have enough resources to comply, so we won't make you comply...wow. Essentially, Harting is saying that Fannie and Freddie don't have enough reserves...but he's saying it 'without saying it'.

So, I leave you with this.

1. Will regulators continue to try to reassure the public?

2. What should you as an investor do if they do reassure the faith in the system (sell or buy)?

3. Will we see a revision of the current accounting system, but more exemptions for entities

with off balance sheet assets?

What's your action plan?