Fannie and Freddie: The Mother of All Bailouts

by Chris Sturr | September 08, 2008

This posting is from D&S collective member and frequent blogger Larry Peterson. To see more of his posts, click here.

Treasury Secretary Henry Paulson finally called time on the financial world’s two biggest deadbeats this weekend, effectively putting the two mortgage behemoths under government control. Although some details remain to be worked out (not least of which is the unprecedented $1.4 trillion of credit default swaps that, technically speaking, amount to defaulted payments in the case of the GSEs (Government Sponsored Entities) being taken into “conservatorship” by the government), the main effects of the takeover are as follows: (1) the government will provide up to $100 billion to both companies to beef up their capital, and the Treasury may ultimately buy the companies at little cost if it chooses to do so; (2) dividend payments (which they were very liberal with, at the expense of capital provisioning) will be eliminated, while payments on debt will be honored; (3) the government, in yet another unprecedented move, will buy significant amounts of mortgage-backed securities on the open market, beginning with a $5 billion spending spree later this month; (4) the CEOs of both companies will be replaced; (5) the companies will be barred from lobbying on Capitol Hill, a skill it learned to master over the years, (6) both companies will gradually reduce their participation in the mortgage markets (a stunning reversal, given the fact that the government was relying on them to increase their presence in the moribund market only a few months ago); and (7) the Treasury will create a “Secured Lending Credit Facility,” or emergency fund in case they companies cannot secure the loans they need to purchase mortgages or mortgage-backed securities on the open market.

In exchange for its largesse, the Treasury will receive warrants (giving them the right of purchase) on 80% of the GSEs’ shares, and $1 billion in cash from each.

What, exactly, tipped the two companies over the abyss? During the past week the shares of both companies rose a bit, as investors came to believe that drastic government action might not be necessary. But then doubts about the GSEs’ accounting methods, an issue that has plagued them historically and during the current crisis, began to come to the fore again. Also, foreign investors, who hold vast amounts of GSE securities, began to pressure the US government to guarantee their debt, even at the expense of equity–and hence the ability to continue business as independent companies. But, according to The New York Times http://www.nytimes.com/2008/09/08/business/08takeover.html?_r=1&oref=slogin, the single most important factor behind the Treasury’s move had to do with Freddie Mac: even more careless about capital provisioning than its sister GSE, Freddie aroused so much uncertainty amongst investors, who feared that if they bought Freddie’s debt now, and the Treasury eventually had to be called in anyway and seized, their investments would be lost. And since Fannie and Freddie’s debt is so important to the operation of the so-called repo- and interbank markets, which lubricate all financial markets, this was something the Treasury simply could not allow.

So what will happen now? Holders of Fannie and Freddie’s shares will suffer. And though many are happy at the thought of wealthy investors being punished, there is an underside of this for the rest of us. As The Financial Times http://www.ft.com/cms/s/0/68a608be-7d3c-11dd-8d59-000077b07658.html points out, US regional banks are some of the biggest holders of Fannie and Freddie stock, and their losses will compound difficulties in the US banking sector, just as worries about the health of commercial banks–themselves increasingly exposed to the commercial property downturn–are coming to the fore. And it is by no means clear that the takeover will unclog the the interbank market. Though Fannie and Freddie may be dead as independent concerns, they may well continue, like vampires, to suck the blood out of the living for some time yet. Who was the guy who used that metaphor again?

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