Morgan Stanley Latest Band-Aid Over Fannie, Freddie's Bullet Hole

This post first appeared on Minyanville and our sister site Dawn Patrol.

It looks like all those short-sellers might have been on to something.

Freddie Mac (FRE), the beleaguered mortgage giant that was just weeks ago on the brink of collapse, released second quarter results this morning that were nothing short of abysmal. Along with the financial backing of you, me and all the other US taxpayers, the government-sponsored enterprise now has:

• $831 million loss or $1.63 per share, compared with net income of $729 million a year ago.
  
• Revenue fell 28% to $1.69 billion compared to last year.
  
• $2.5 billion in credit loss provisions and $1 billion in mortgage-related writedowns.
  
• Board approval to slash dividends from $0.25 per share to “$0.05 or less”.
  
• The intention to raise $5.5 billion or more in fresh capital.

Although the company currently meets capital requirements demanded by its regulator, the Office of Federal Housing Enterprise Oversight, it may fall below those levels if the housing and credit markets continue to deteriorate.

Last month, shares plunged on fears that Freddie and its larger cousin Fannie Mae (FNM) would crumble under the weight of mounting losses in their massive mortgage portfolios. The Treasury Department tried to shore up confidence by demanding Congressional approval to support the 2 companies, should the need arise.

Treasury announced this week it had hired Morgan Stanley (MS) to help sort out the mess and assess the two companies’ financial positions.

It takes a very active imagination to think a company capitalized with just $37 billion to support more than $2 trillion in U.S. mortgage debt is anything resembling stable.

Although Fannie and Freddie managed to avoid buying the worst of the subprime mortgages originated during the housing boom, many equally toxic Alt-A and other non-prime loans made it onto their balance sheets. Even marginally savvy originators were able to exploit their automated underwriting and risk systems, resulting in the loss of billions of dollars from questionable loans.

Fannie and Freddie are now paying for their transgressions - or rather, the American taxpayer is paying, since Congress gave Treasury Secretary Hank Paulson what amounts to a blank check to bail out the two failed companies.

The only questions left are: When will Fannie and Freddie collapse, and what form will they take thereafter?

Many advocate for privatization, splitting the firms into several publicly traded companies. Others, mindful of the Federal government’s tendency to privatize profits and socialize losses, expect outright nationalization.

One near-certainty, irrespective of the outcome of their current crisis, is that Fannie and Freddie's ability to keep mortgages rates artificially low will be greatly reduced. That doesn't bode well for anyone considering buying a house in the next 20 years.

Mortgage Reform: Why Government Intelligence is Oxymoron

This post first appeared on Minyanville and our sister site Dawn Patrol.

After leading the banking sector to its largest ever one-day drop yesterday, Washington Mutual (WM), in an effort to assuage concerns that it's facing a cash crunch, released a statement claiming that the bank is "well-capitalized."

Though the stock bucked the trend this morning as the broader financial complex continued its unrelenting sell-off, shareholders aren’t likely to be comforted by the WaMu’s pleas for calm.

The largest savings-and-loan in the country has seen share prices fall below $4 following the seizure of IndyMac (IMB) by benevolent federal banking regulators; investors fear WaMu could be next.

IndyMac was reopened on Monday to handle endless lines of depositors hoping to recover their pennies from the bank’s coffers.

In a stark reminder of just how dicey bottom-picking can be, Bloomberg reminded us that private-equity firm TPG led a consortium of investors in providing the bank with $7 billion in much-needed cash in April, when the stock traded at $13. Those daring saviors have seen most of their investment wiped out.

TPG did, however, slip a protective clause into the deal: If the stock drops below $8.75 -- which it clearly has -- TPG is owed the difference, effectively putting the bank on the hook for its own equity losses. While protecting TPG's investment, this feature also makes it considerably more costly, if not impossible, for the bank to raise more capital, which would further dilute shares.

As more details emerge about these and other onerous terms with which banks have been forced to agree in their efforts to raise capital, it's becoming clear just how misguidedly optimistic investors were when such deals were first announced. Banking expert Minyan Peter wrote of the WaMu deal:

“I think the problem for most market participants right now is the assumption [that] what we're experiencing looks something like 'their prior experiences in banking crises.' And to me, that's why we have seen such a big rally over the past two weeks -- because, based on prior experience, a rally feels very right, right about now.

But for all the reasons I shared before, this one is different.”

We’re now seeing just how different this one is.

Professor Depew explained Friday how the Fannie Mae (FNM) and Freddie Mac (FRE) crisis is different from the Long-Term Capital Management failure in 1998: In this case, massive losses by financial institutions around the world are a symptom, not the cause.

A few misplaced bets aren’t to blame for the market turmoil; neither is rumor-mongering. The financial system’s problems, and by extension the economy’s, are rooted in years of mispriced risk and excessive leverage. Markets are now witnessing the destruction of that debt at a rate that’s stomach-churning to the traditional buy-and-hold investor.

The process, though painful, is necessary. The debt will be destroyed, firms will go out of business and the economy will slow, if not contract. All this is healthy. Agonizing, to be sure, but healthy.

As Toddo wrote yesterday on the Buzz and Banter, “The big picture blues will lead to an unfortunate destination, but that’s necessary to rebuild the foundation for sustainable economic growth. Once we get there, those with capital will be in a fantastic position to prosper.”