The financial sector is reeling yet again over woes from GSE’s.  In fact, there are now many traders betting that one or both are effectively worthless for common holders.  Both Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are under severe pressure yet again over liquidity concerns. 

The Wall Street Journal has reported that the government doesn’t expect them to fail, but that the White House has discussed the "what if" scenarios if a failure were to occur.  A package from the Federal Reserve is also said to have been discussed.

But then something came out of Bloomberg that throws a wrench into this machine.  William Poole, a former president of the Federal Reserve Bank of St. Louis, told Bloomberg that Congress should recognize that the GSE’s are effectively insolvent after losses.  He also noted that the odds are higher that the U.S. will have to bail them out.

The ramifications on this issue are more than wide and more than far reaching.  We covered back in January how many of the financial firms (you could now include the GSE’s perhaps) might be forced to merge whether they want to or not and we identified the winners and losers in there.  Could Fannie & Freddie end up being one entity? By charter that might not be allowed but we still think those charters are pieces of paper that can have a pen and ink change.

But think about the ramifications if one of these or both of these actually failed.  If you thought a Bear Stearns meltdown would have caused a panic, "you ain’t seen nothing yet" sure comes to mind.  It isn’t that the lending institutions would be changed for future mortgages.  The ramifications for the entire financial system would be at risk.  Imagine if all the outstanding debt issuances, mortgage-backed securities, CMO’s, and other pieces of paper widened out to massive spreads over treasuries.  You would have write-down waves at banks, brokers, insurance companies, credit unions, every pension system, mutual funds, and private money managers.  It would effectively destroy more value in just about every portfolio that exists.

One thing has helped very briefly and that is comments out of Treasury chief Hank Paulson noting that Fannie and Freddie are both adequately capitalized. 

As of last quarter, Fannie Mae listed its total liabilities as $804 Billion.  Freddie Mac’s liabilities are listed as being some $786 Billion.  According to both, the total assets are higher than this, but anyone trusting the actual "values" right now might be a bit too trusting in the good old written word. 

Letting one fail would cause the likely fallout to cause the same at the other.  Go ask the public and go ask most Wall Street professionals what the real difference is between Fannie and Freddie.  The answer is going to be "I don’t know."

Shares of both companies are down significantly.  The only  bit of good news here is that Paulson’s comments did at least create a bid.  Fannie Mae shares are down 18% at $12.57.  Freddie Mac shares are continuing to slide though with its shares down 29% at $7.16. 

If there is a plan to save these or a plan to combine these or any plan at all, it better come fast. Either way, further regulation and de-leveraging seem to be about as certain as death and taxes.

Jon C. Ogg
July 10, 2008

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