Freddie and Fannie in Free Fall

The dike might be cracking on the U.S. financial system and U.S. regulators are trying to figure out how to make sure it doesn't burst.

Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) , the behemoth caretakers of U.S. home ownership financing, are looking increasingly unstable. Their demise would spell disaster, and the U.S. cannot allow that to happen.

The market went nuts this week as former St. Louis Fed President Albert Poole suggested that Freddie Mac is technically insolvent. What does the market think? As of Friday morning, Fannie and Freddie stock were down 53% and 64%, respectively ... just this week! I think the market has weighed in with an opinion.

Why are the stocks nose-diving?
Investors are wary of the mortgage lenders for two main reasons. First, falling housing prices and rising mortgage defaults are expected to result in massive losses. This is combined with some of the subprime infection on their balance sheets similar to what Merrill Lynch (NYSE: MER  ) , Citigroup (NYSE: C  ) , and UBS (NYSE: UBS  ) are experiencing. Second, the losses may require them to raise capital ... and that could massively dilute shareholdings.

Not only are the stocks of the two lenders getting hammered, but the bonds are also taking a big hit. Although Fannie enjoys an implied government guarantee and a AAA rating, lenders are demanding higher rates. Fannie issued $3 billion in two-year bonds this week at a spread of 0.74% above the Treasury rate. This spread is almost triple the difference of two years ago and double that of one year ago.

How bad is it?
Poole said that Freddie currently has more liabilities than assets. By standard accounting principles, this makes it insolvent. Many believe that Fannie will be in the same boat very shortly. If the mortgage lenders cannot raise sufficient capital to cover their balance sheet losses, they could fail.

According to The Wall Street Journal, the Bush administration has held ongoing meetings with regulators concerning possible actions if the massive mortgage lenders fail. 

How bad could it get?
What would happen if Fannie and Freddie were to fail? The housing market simply could not function without them. Consider this: The mortgage lenders guarantee or own one-half of all U.S. mortgage loans, or about $5 trillion worth. The ramifications on the U.S. and world economy would be catastrophic.

The government simply cannot let them fail. If push comes to shove, how can they be saved? The government could bail them out by having the Federal Reserve purchase mortgage assets in exchange for liquid Treasuries, or the U.S. government could simply guarantee the mortgage lenders' obligations. Either way comes down to a government or taxpayer bailout, perhaps a massive one ... the companies have an estimated $1.5 trillion in debt.

Foolish bottom line
Fannie and Freddie will most likely be able to raise capital and take care of themselves. The government doesn't expect them to fail. Government authorities are just planning prudently. But, if the lenders can't raise sufficient capital, the taxpayers will simply have to bail them out, no matter what it costs. The repercussions of not doing so would be unthinkable.

Related Foolishness:

Fool contributor Tom Hutchinson holds no financial position in any companies mentioned. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 11, 2008, at 8:51 PM, ljpclark wrote:

    FMN & FRE have been absorbing huge amounts of known "toxic-waste"(aka known bad debt/sub prime paper) in the past few months. Buying up this "toxic-waste" from the banks at a point in time when all the world by this time knows the magnitude of the problem is negligent (knew or should have known) or reckless(reckless disregard for the consequences). Now the cry "we're too big to fail"! Reminds me of the man who killed his his parents and then pleaded for the mercy of the court because he was an orphan.

    In the present "heads I win / tails you loose" management being applied to this so called sub prime crisis rich bankers get bailed out and the American taxpayer gets burdened for generations to come.

    Looks like the privatization of profits for the banking/Wall Street elite and the socialization of loss and risk for the good 'ol Taxpayer.

  • Report this Comment On July 12, 2008, at 8:13 AM, jkinsley wrote:

    Are the repercussions actually unthinkable? Why don't you actually *think* about it and tell us what the repercussions would be?

  • Report this Comment On July 12, 2008, at 5:34 PM, marysc wrote:

    My question now: what are the pros and cons of buying Freddie and Fannie stock at this point? If worst comes to worst, the govt will step in and rescue them, right? And where else can they go but up in the next few quarters? Is my reasoning completely off base? I would love to hear some comment on this matter, as I have some money I need to invest while stocks are low.

  • Report this Comment On July 14, 2008, at 3:11 PM, KWT8011 wrote:

    marysc,

    This may not be completely comparable, but look at what happened to Etrade after being downgraded with rumors of bankruptcy. It rebounded a little in the short term but YTD it's down 31%. Better to find a good business than try to cherry-pick beaten down stocks.

  • Report this Comment On July 16, 2008, at 3:41 PM, irvhomer wrote:

    I concur with ljpclark and jkinsley. The only thing that strikes me as unthinkable is a government bailout of these companies. Both of these companies should be, and should have always been, 100% privatized. When the government (taxpayer) covers the risk, businesses make risky decisions. This was eventually the same problem with the S&L’s.

    Tom, you should better explain and support your statement that letting these companies fail would be unthinkable. At the very least, the message should be sent to them that they are on their own. If they know they’ll be rescued with taxpayer’s money, what incentive will they ever have to run an efficient business and to responsibly mitigate risk?

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