End of Fannie and Freddie As We Know Them

The above headline from MarketWatch.com captures, what may turn out to be, the largest government bailout in history. Fannie Mae and Freddie Mac are being placed in conservatorship. You can get more detailed information from blogs such as The Big Picture and Calculated Risk.

To recap, Fannie Mae and Freddie Mac are being taken over by the US government. It involves massive capital injection into the two entities, for which the government will receive preferential preferred shares and warrants. The plan also involves the US Treasury buying Fannie and Freddie MBS in the open market (one article said The Federal Reserve is the one that will be carrying this out but I believe it's actually the Treasury.) The plan does not eliminate either the preferred or common shares so holders will have something left, and it will likely also prevent CDS being written on the two firms from being triggered (but that depends on CDS legalities which I'm not familiar with.)

According The Big Picture, the warrants are worth up to 79.9% of equity, so shareholders will take a huge hit.

Dividends on existing preferred shares are being cut, and the new government-owned preferred shares have preferential rights so I imagine preferred shareholders will also get hit big time. However, unlike the common shareholders whose shares will probably decline up to 80% tomorrow, the preferred shareholders will face a variable amount of dilution depending on future performance of the mortgage markets. If things deteriorate, the government will keep pumping more money into the firms and hence dilute the preferreds further, in addition to potentially not receiving any dividends for holding the preferreds. But if things recover, the preferreds have the potential to recover.

I'm not sure how the stock and bond markets are going to interpret all this. The way I look at it, it is very bearish for the GSE shares, US$, and for small banks owning GSE shares; while bullish for GSE MBS, mortgage insurers, the housing market in general. It'll be up to the future presidential administration and congress/senate to decide what the end game will be. After this mess, ideal solution would be to wind down their operations over the next 20 years. I don't think it will be possible to spin them off to private investors in the future. It will also be very risky to operate them as they are, given their massive--trillions!--exposure.


One final note... the Fannie and Freddie outcome is the worst form of capitalism and goes against everything that I consider desirable about capitalism. Hundreads of billions of profits were earned and paid out to private investors over the decades, while the potentially massive losses in the end are being borne primarily by the public. I don't think there are many other choices right now so the decision is probably right; but someone should have stopped this from spiralling out of control many years ago.

This situation is one of the reasons I am generally against public-private partnerships. You almost always end up socializing losses while the profits accrue to select individuals. To make matters worse, knowing that the government will help them, it often results in public-private entities gambling and taking on higher risk than would have been feasible in a free market without government support.