The federal government has decided that Fannie Mae (FNM) and Freddie Mac (FRE) are too big to fail. The Fed and Treasury will offer a combination of loans and stock purchases to make sure that the two mortgage operations have adequate capital to operate smoothly. By some estimates, the government will put $15 billion into the companies, which will almost certainly push down the value of their common shares due to dilution. But, it will not wipe that stockholders out.

Investors and employees at Bear Stearns were not so lucky. Shareholders in IndyMac (IMB), which was seized by the government last week, will walk away with nothing. People with money in Countrywide would likely have done no better if Bank of America (BAC) has not bought the company, a move that some analysts say could still back-fire.

The Fed and Treasury almost certainly did the right thing. Those who believe that only the free market should determine the fate of financial institutions may want to make an exception with FRE and FNM. They hold or support almost 50% of US mortgages. Their paper is owned in great quantity by every major bank and brokerage house. A failure of one or both companies would cause hundreds of millions of dollars in bank write-offs and would hurt the chances of the average citizen getting a home loan.

The credit crisis, but most measures, is getting worse. Merrill Lynch (MER) is almost certainly close to selling assets to offset losses from its mortgage-related paper. Most large US banks, with Citgroup (C) out in front, are going to have billions more in write-downs this quarter. Many observers think those losses could continue well into next year as the mortgage markets and economy get worse.

All of this raises the $64,000 question of which financial institutions are too big to fail and which are not. It could be persuasively argued that if MBIA (MBI) or Ambac (ABK) went under, the losses at financial companies which hold their paper could be tremendous.

That brings the argument around to money center banks and brokerages. Market rumors are that Lehman (LEH) may not make it. Wachovia (WB), Washington Mutual (WM), and Citigroup (C) may reach a point of no return. Who decides if any of these gets government assistance? Congress? The Fed? The Treasury?

The credit crisis will get worse, perhaps much worse. The federal government does not have an unlimited supply of capital. If it is faced with bail-outs that run into the hundreds of billions of dollars, the vault may empty quickly.

All of this means that the decision about what happens to large US banks and investment houses will be at least somewhat arbitrary.

Those financial firms which fail earliest may actually have an advantage. At least there will be money available to support them.

Douglas A. McIntyre

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