The Bailout Is Official

The Government has just announced (Sunday) a landmark bailout for Freddie Mac & Fannie Mae.  This isn’t a big surprise.  A couple of months ago, they told us they would step in if necessary.  Since that time, the stocks of both companies went way up and way down.  Speculators were trying to make quick money on the trades.  But, most believed the stocks would end up worthless.  It appears they may be worthless Monday morning.  I’m a little surprised the bailout didn’t come earlier.  But, apparently, they’ve been working on this bailout for several weeks.

Under the plan, the U.S. Treasury will purchase up to $100 billion of mortgages and provide short-term financing to the two companies.  The Treasury will receive $1 billion of preferred shares that pay a 10% coupon paid quarterly.  The government also receives warrants which could give them roughly 80% ownership in the two companies, effectively making the stock worthless.  As part of the plan, Fannie & Freddie will have to reduce the amount of mortgages they own over a scheduled time frame.  The dividends will be immediately elminated saving the companies $2 billion annually.  I’m not sure why the dividends  weren’t eliminated months ago.  The two CEOs have been replaced effective immediately as well. 

The reason this bailout was necessary is because these two companies control almost half the mortgages outstanding (roughly $5 trillion).  In addition, their bonds are held by major instiutions around the world and governments around the world.  Their failure would have had a major ripple effect that would have been devastating.  As I purchased millions of dollars of sophisticated high yielding Fannie & Freddie bonds over the years, I knew that if anything ever happened to these companies, the government would be there to bail them out.  That’s why they have the AAA/aaa rating.  So, today, I just got the upgrade of upgrades on my bonds.  I still own them and I’m still receiving high single and low double digit returns on average on these bonds.

Now, with that said, I don’t believe these companies ever should have been quasi government agencies.  I think you either are or your not a government agency.  Too many conflicts of interest.  And, the situation they are presented with today is precisely why.  Should we treat them as a private company, or a government agency?  Well, they are being treated as a government agency for now.  Who knows how they will be structured in the future. 

Here’s why we’re in this situation.  These agencies were set up specifically to buy mortgages and re-package them and sell them as investments.  That provided liquidity and an opportunity for many homeowners to realize their dream of home ownership.  But, these companies own almost half of the mortgages and they have done it with 50 to 1 leverage.  That’s like you going out and buying $5,000,000 worth of stock with $100,000 cash.  A 10% move in your positions can be devastating.  As long as prices keep going up, everyone is happy.  But, they aren’t going up.  Home prices are going down and they will continue to go down for some time.  You and I are only allowed to borrow up to 50% of your stock portfolio.  Fannie & Freddie are leveraged 5000% if my math is correct.

If the plan works effectively, it could actually make money for the Treasury as opposed to costing taxpayers money.  We’ll have to see how it works out in the future.  The next administration will have to figure out how they will deal with this long-term.  But, for the short-term, it was a necessary move.

As far as the stock market, I’m not sure how the market will react.  I suspect financials will like it as the wheels have been greased and lending and borrowing may be easier.  The government can now come in and change the rules on the mortgages they buy.  They can extend the loan and re-amortize them.  The possibilities are endless.  I personally have a problem if they start doing stuff like that.  If they do that, I’ll expect my mortgage get extended as well. 

This is one step to cleaning up the financial crisis.  It’s not the solution.  It should make for an interesting Monday.

Back to football.

1 Response to “The Bailout Is Official”

  1. 1 darkhorsetrader September 7, 2008 at 5:13 pm

    Thanks for the insightful reporting on the issue!

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