Saturday, September 6, 2008

Fannie and Freddie Bailout

Voltron says: There is some kind of bailout of Fannie Mae and Freddie Mac that will be announced on Sunday. Rumors abound. At question is to what extent the stock holders, the preferred stock holders and bond holders will take a loss. Fannie and Freddie financed $5 trillion in mortgages. That's half of the mortgages in the U.S. and comparable in size to the national debt. F&F are not government agencies, but the people treated them as if they were. As a result they were able to borrow money very cheaply, and people were willing to lend to them because they got paid a little bit more than if they loaned money to the government. As private profit seeking companies accountable only to the shareholders, they acted rationally; they made as many stupidly risky loans as they could as quickly as they could to make as much money as possible in the shortest amount of time. They were also embroiled in accounting scandals and their accounting is still a mess and nobody knows what lurks in their $5 trillion portfolios of exotic financial instruments. When I say nobody I mean NOBODY, including themselves. They eventually became "too big to fail." Much of that debt is owned by foreign governments which whom we have a trade deficit, such as China and Japan. They (wrongly) view the debt as U.S. government debt and it would be a diplomatic disaster if F&F defaulted. Many banks own the preferred stock because the dividends has special tax treatment (thanks again, government). There are also trillions of dollars in credit default swaps - i.e., insurance on F&F debt that will trigger a massive cascade of bankruptcies if F&F ever defaults. So here we are. I'll post the details and my analysis when they are announced. In the meantime, enjoy Treasury Secretary Paulson getting schooled by Sen Jim Bunning (R-Kentucky) when he asked congress for a blank check to defend F&F.

He got what he asked for.

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