Editor's Note: This is the second part of a 2-part series. Part 1 can be found here.

More Thoughts on Fannie and Freddie

First, let me correct an error: It wasn't JPMorgan (JPM) that Treasury Secretary Hank Paulson asked to come up with a plan to fix Fannie (FNM) and Freddie (FRE). It was Morgan Stanley (MS). Sorry.

Warren Buffett has stated that Freddie and Fannie are toast, as have many establishment analysts. Buffett told CNBC that the firms had no net worth and would need tens of billions in capital to shore up their balance sheets. Since their combined capitalization is less than $6 billion, it is unlikely that there is any way they could get even a sovereign wealth fund to come to their aid in the form of stock.

Congressional oversight committees estimate losses for Fannie and Freddie to be $25 billion, given current housing values. As home values drop, those estimates keep going up. Also, as the economy gets worse, those losses will increase. Independent estimates are double that or more. If only that were the extent of the problem.

There is $36 billion in preferred shares as of June 2007. Then there is $19 billion in subordinated debt. These firms back $5.2 trillion in mortgage securities. As an aside, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss. Care to make an over/under wager on a 1% loss by this time next year? I don’t think I would want the under.

Gretchen Morgenstern reported last week that there are -- drum roll -- $62 trillion (with a “T”) in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt. Even if you cut this in half – because technically, when a buyer and a seller enter into a single transaction they create twice the value of the transaction in credit derivatives - a huge sum, far out of proportion to the underlying assets. More on this later.

The team at Morgan Stanley has a very interesting problem to solve. It is not just about putting $25 to $50 billion into Fannie and Freddie (assuming that would be enough). If that’s all it was, just issue preferred shares, wipe out the current shareholders and, as the smoke cleared in a few years, even with less leverage the actual value of the two companies might actually approach that number and some private equity firms could take out the US taxpayer.
But it's not that simple.