Teflon Bonds
Marilyn Cohen, Forbes Magazine, 07.03.06

What do greedy chief executives, derelict directors, fake earnings and humongous government penalties all have in common? Fannie Mae and Freddie Mac. These government-sponsored enterprises, whose misdeeds were a tame version of what went on at Enron, have seen plenty of negative news in the past few years.

Stock in Fannie Mae , the worse offender, has swooned as a result. In September 2005 when investigators found a new crop of accounting violations atop the harvest they reaped the year before, Fannie's shares slid 11%.

Today they sit at $50 (versus $88 at their December 2000 high). The company had a cookie jar of reserves that it dipped into in order to smooth earnings, taking the edge off poor results and pulling back good ones that would set too high a mark for later. Fannie also monkeyed around with derivatives that allowed it to spread losses over a number of years instead of recognizing them at once.

These ploys let Fannie's management pocket rich bonuses. Since the scandal came into public view Fannie's chief, Franklin Raines, has been sent packing, although his number two guy, Daniel Mudd, is in charge now. Following release of a late-May report from federal regulators, Fannie agreed to pay $400 million in fines, just part of what it has had to shell out because of the accounting mess.

Freddie Mac has caused less shareholder agita, but its sins are almost as egregious. It also manipulated earnings to keep them on a smooth upward climb, deferring unanticipated earnings to later periods. Its headman, Gregory Parseghian, got the bounce because of his active participation in the strategy. In April Freddie paid $410 million to settle a class suit.

So what has happened to their bonds? Well, they are evidently Teflon-coated. Fannie and Freddie bond prices have barely moved. Their credit ratings, from both Moody's and Standard & Poor's, remain unblemished at Aaa and AAA. How odd. Typically nowadays a financial restatement or missed regulatory filing date can put a bond on negative credit watch immediately; no waiting until too late, as happened in the Enron and WorldCom era.

The high credit ratings are attributable to a perceived implicit guarantee of government backing. It is generally assumed that if something went seriously awry, the Treasury would bail out the troublesome twosome, lest they harm mortgage issuance, a linchpin of the economy and the banking system. But no law obliges the government to stand behind these mortgage funders.

To see how the bond market is shrugging off the Freddie and Fannie imbroglios, let's compare their bonds to those of two agencies that don't carry the same baggage: the Federal Farm Credit Banks (37 of them, which make loans to farmers and ranchers) and the Federal Home Loan Banks (12 regional entities that lend money to savings and loans, thus aiding mortgage issuance). These smaller, less-heralded organizations differ from Freddie and Fannie in not having publicly traded shares.

In May and early June all four issued callable bonds that mature in 2011. Their structures are not identical but close enough. Fannie's 6% bond is callable on Nov. 24, while the Federal Home Loan Banks' 6% of June 1, 2011 can be called on Dec. 1. Several weeks after the bonds were floated they both yield 6%. No difference. Unlike Fannie and Freddie, the home loan and farm credit bank bonds pay interest that is not subject to state income tax.

Freddie Mac's 5.75% bond due May 11, 2011, with a one-time call on May 11, 2007 at par, has the same coupon and yield as the Federal Home Loan Banks' 5.75% of May 25, 2011, callable May 25, 2007. The Federal Farm Credit Banks' 5.84% of June 1, 2011, callable June 1, 2007, offers a coupon a hair bigger.

Given a choice between tainted issuers and those that aren't, you should take the latter. Buy Federal Home Loan Banks' and Federal Farm Credit Banks' bonds and take a pass on the Freddies and Fannies.

Freddie and Fannie have successfully weathered past blow-ups. But there's a drip-drip-drip factor. Every time we hear assurances that all the bad stuff is behind these two, another nasty revelation comes forth. Expect more ahead. The Justice Department is continuing its investigation of Fannie Mae.

A point will come when big investors, notably public pension funds and foreigners, will have had enough. The bonds will sell off. So stay away if you're not getting paid for taking on the extra risk of these creatures.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at http://www.forbes.com/search/results.jhtml?RD=DM&MT=marilyn%2Bcohen&date=&author=&sort=.