Eddie Lampert, as Chairman, wrote a letter to shareholders of Sears Holdings Corporation in February 2009. Interestingly, the letter contained a detailed and insightful analysis of the situation with Fannie and Freddie. It’s a longer letter but the section about Fan and Fred is here:
Pressure from foreign lenders and other significant participants in fixed income markets increased as concerns were raised about Fannie Mae and Freddie Mac, the two Government Sponsored Enterprises (GSEs) that are the largest providers of liquidity to the mortgage markets. The GSEs had been for a long time a political football, with some conservatives urging their elimination and some liberals urging them to do more lending to lower income communities. As investors reevaluated their risk tolerance, a flight to quality ensued, with many investors shifting their preference to cash and to risk-free Treasury securities. The credit spread over Treasury securities for high-grade corporate bonds as well as GSE debt increased (even though the absolute level of rates was still very low), generating losses amongst many fixed income participants, including foreign lenders and large fixed income mutual funds and investors.
In July 2008, Congress was persuaded to act. Under the advice and urging of the U.S. Treasury, Congress passed the Housing and Economic Recovery Act of 2008, which increased the oversight authority of the regulator of the GSEs, ultimately giving the Secretary of the Treasury a “bazooka” to fire at the GSEs and their shareholders under certain conditions. As the Treasury Secretary explained at the time, “if you have a bazooka, and people know you’ve got it, you may not have to take it out. You’re not likely to take it out.” This gave a temporary reprieve to worried GSE investors. Immediately after passage of the legislation, however, many in the media began to call for the nationalization of the GSEs. Depending on their vantage point, people argued either about the GSE’s ability to fulfill both a social and an economic mission simultaneously, or about why they existed in the first place.
On September 7, 2008, in the largest nationalization in American history (executed expeditiously and without an obviously transparent process), the U.S. government announced that it was placing Fannie Mae and Freddie Mac into conservatorship. As part of the conservatorship, the government would provide capital support, if necessary, of up to $100 billion to each GSE through Preferred Stock Purchase Agreements. Although no cash changed hands, in consideration of this backstop, the U.S. government received 80% of the common stock plus $1 billion in preferred stock in each institution. This backstop has recently been increased to $200 billion as part of the Homeowner Affordability and Stability Plan. In the process, they suspended dividends on existing preferred stock of both Fannie Mae and Freddie Mac, eliminating approximately $36 billion in value, most of which was held by the major commercial banks in the United States.
Rather than help solve the housing and mortgage problem, the unintended consequences of this action were manifold. First, bank capital was depleted. Not only was $36 billion in GSE preferred wiped out, but the whole market for financial preferred securities went into a free fall, wiping out additional equity from financial institutions, including many large insurance companies. Second, despite the boards of directors of Fannie Mae and Freddie Mac consenting to conservatorship, neither company has ever given an explanation for its consent. For those who are sophisticated in finance, neither Fannie Mae nor Freddie Mac had a “funding” problem. Because each GSE’s balance sheet was comprised of highly liquid Mortgage Backed Securities (MBS) that pay off on a monthly basis, it should have been easy for either to pledge securities to raise money or to shrink their balance sheet and meet their financial obligations as they came due. The logical explanation for the boards of directors giving consent rests with the presumption that if they did not consent, there was some other threat that would have been even worse for those directors. As for the shareholders the directors represented, it is hard to imagine anything worse than having their investment effectively wiped out, and they had no vote on the matter.
Investors in regulated industries rely on the fact that regulators will not behave in an arbitrary fashion and, if they do, that there are due process remedies that their managements and boards can pursue. Investors in financial institutions who experienced what can happen when funding was compromised earlier in the year in the case of Bear Stearns, now experienced what can happen when a regulator unilaterally decides that the rules of the game are not sufficient or appropriate. Both Fannie Mae and Freddie Mac had capital in excess of the required levels under regulatory guidelines and accounting rules in effect, with Fannie Mae’s capital being significantly in excess of the required levels. However, if one were to use some other standard (and many were being suggested and recommended for quite a while), one could make the case that neither company had the capital desired by their critics, some of whom were not investors, while others had an academic or political interest in the housing and mortgage area that was adverse to the GSEs.
Once it became clear that regulators would act preemptively and with apparent disregard for the regulatory capital requirements and rules, it took less than one week for Lehman Brothers, AIG and Merrill Lynch to find their funding compromised. The government then made the decision to let Lehman Brothers fail, rather than to provide some form of funding bridge that would allow them to meet their short-term obligations and shrink or reform their balance sheet in an orderly fashion. Merrill Lynch agreed to be bought by Bank of America, thereby securing funding for its obligations. The government stepped in to provide bridge financing to AIG. Goldman Sachs and Morgan Stanley were allowed to become bank holding companies on an expedited basis, thereby strengthening their liquidity positions through an expansion in the types of assets they could pledge at the discount window. This provided both companies a strong boost and enabled their survival, while eliminating the last of the major investment banking firms.
The willingness to let Lehman Brothers fail, the stringent terms of the AIG bridge loan, and the arbitrary nature of helping some and not others was too much for many investors to bear. Confidence – which was already strained earlier in the year – was destroyed by this series of events, and unforeseen consequences continued. Shortly thereafter, Washington Mutual was seized and sold to J.P. Morgan, Wachovia agreed to be acquired, first by Citigroup and then by Wells Fargo, and National City was forced into the hands of PNC.
To simplify, there were two paths being pursued simultaneously to strengthen the financial system in general and individual companies specifically. First, there was the capital raising path. This path has generally not worked and has been both value and confidence destroying. Yes, it has given support to creditors (depositors, lenders and others) of financial institutions, but it has destroyed their stock prices, which for many are the primary indicator of confidence. Raising capital at any price or achieving the same effect through forced mergers, and doing so at a time when regulatory capital levels were at or higher than historical levels, made investors wary of buying financial securities and caused many investors to sell these securities. Second, there was the funding path. This path has worked very well and was buttressed later in the year by guaranteeing deposits at a higher level, allowing banks to issue government guaranteed debt, guaranteeing money market funds and providing access to commercial paper for higher rated borrowers. A business that has access to funding can continue to operate, generate earnings, and increase its capital to repair its balance sheet.
The market often has a short memory – but not that short. Recent speculation about bank nationalization, uncertainty regarding regulatory standards, and the loud drumbeat of speculation are eerily familiar. The dangers of regulatory action that is poorly understood and consequentially significant are fresh in the minds of investors and citizens alike. Just as our nation’s leaders can contribute to a downward spiral of confidence they can also contribute to an uplifting of confidence. And this is not just about words. Any actions that contribute to respect for private property and the rule of law will be immediately greeted by improved investor sentiment. Whether as a bondholder or stockholder, investors need to know that they have rights and that the rules of the game are going to be fair and predictable. Any rule changes or actions should not simply be decided and announced over a weekend. Improved oversight can be constructive. Allowing significant policy changes to work their way through the system over time, rather than implementing them overnight because of stock price declines, can break the cycle of panic and fear.
The reason I have elaborated on these events is to put into perspective the environment in which companies like ours are operating. While all companies are impacted by the frozen credit markets, retail companies are impacted by reductions in funding from banks for their seasonal needs to build additional inventory during the Christmas holiday. This has had a crippling effect on some, both large and small, who are no longer in business. The credit markets have also impacted customers in terms of the availability of credit card financing and other funding for their purchases. When funding sources become less predictable, a retailer, or any other business for that matter, needs to adjust so that it doesn’t find itself without the ability to operate successfully.