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Fannie & Freddie - Holding Back The Tide, Part 1


Staying afloat after the bailout.


The US Treasury's "rescue" package for Fannie Mae (FNM) and Freddie Mac (FRE) elicited a spectacular reaction from financial markets. In a triumph of hope over knowledge, markets betrayed their essential "romanticism." As John Maynard Keynes observed: "It is necessarily part of the business of a banker to profess a conventional respectability which is more than human. Lifelong practices of this kind make them the most romantic and the least realistic of men."

The Fannie and Freddie show had all the staged, stylized and utterly predictable drama of Japanese Kabuki theatre. Confusion over objectives, aggressive expansion, increased risk-taking, inadequate capital, occasionally controversial accounting and frequent political interference led to entirely predictable financial problems, and ultimately to the inevitable government "bailout." In July 2008, one headline proved prophetic: "Fannie et Freddie, c'est fini!"

Established by the
government and then subsequently privatized (Fannie Mae was sold into private ownership by the Johnson administration to help finance the Vietnam War), successive administrations have used the GSEs to create liquidity and support the financial system in times of stress.

In 1994, the GSEs expanded their balance sheets (chiefly holdings of mortgages and mortgage-backed securities, or MBS) by $150 billion (double the previous year's expansion) to reduce the effect of the bond market collapse.

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GSE balance sheets expanded in the period 1998 to 2001 in response to the Asian monetary crisis, Russian default, LTCM collapse and end of the Internet and Telecom boom: $305 billion (1998); $317 billion (1999), $238 billion (2000) and $344 billion (2001). Since 2007, the
government has used Fannie and Freddie to increase mortgage lending to help ameliorate the effects of the sub-prime mortgage crisis.

Under the bailout proposal, the government will commit to purchase (up to) $100 billion in 10% coupon-preferred stocks in the company, consisting of an initial commitment of $1 billion and warrants for 79.9% of common stock. The aim is to maintain positive net worth of the entities.

The government will also provide funding to Fannie and Freddie secured against the GSEs' MBS and the Federal Home Loan Banks (or FHLB). The structure of the support package avoids "ambiguities in the GSE Congressional charters" and benefits shareholders.

The plan falls short of a full-faith unconditional
government guarantee of GSE obligations. There are advantages tactical advantages in this arrangement. Continuation of Freddie and Fannie as "implicitly" but not "explicitly" guaranteed entities creates a cover of "plausible deniability" for higher costs on its borrowings without increasing the cost of Treasury bonds.

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