Sunday, August 24, 2008
The saga surrounding Fannie Mae and Freddie Mac continues. Although most of it is just speculation, share values of the two giants did drop precipitously, again, this week. On Tuesday, shares plunged 22% on speculation that a government bailout is imminent.
The investment community is incensed. According to Reuters, [Warren] Buffett called them "too big to fail" and said "the game is over" for them as independent companies. "In a practical sense, as institutions, they don't have any net worth," he said.
So how did Fannie Mae and Freddie Mac become too big to fail? Simple: As government sponsored entities (GSE), Fannie Mae and Freddie Mac have been funding their operations (borrow) at rates ridiculously close to that of the US Treasury.
In 2006, the average spread between a Fannie Mae 10-year bond and a US Treasury 10-yr bond was just 0.37%. With the implicit (now explicit) government backing, Fannie Mae and Freddie Mac are seen as close to default as the US Treasury. Does that make sense to you?
Corporate debt yields should exceed significantly US debt yields because the expected default rate is much higher. In 2006, the average spread between a Moody’s BAA-rated firm and the US Treasury was 1.6%, and for a AAA-rated firm, it was 0.72%. Fannie Mae and Freddie Mac are highly leveraged, more so than most firms, and should be rated accordingly; the spread to US Treasuries should well-exceed 0.37%. Finally, Moody’s downgraded the two giants on Friday, and yields jumped.
Economists far and wide are outraged over the bail out of Fannie Mae and Freddie Mac. A Bloomberg report with Jeffrey Lacker, President of the Richmond Federal Reserve Bank reads:
"For my money I would prefer to see them credibly and demonstrably privatized,'' Lacker said today in an interview with Bloomberg Television. He agreed with former Fed Chairman Alan Greenspan's view that the two largest U.S. mortgage finance firms ought to be nationalized, then split up and sold off.
Why would an economist prefer nationalization? Bailing out the two mortgage giants involves the US Treasury extending loans financed by US taxpayers (you and I). The problem is that you and I (taxpayers) will then share the liabilities of Fannie Mae and Freddie Mac, but the shareholders still enjoy the assets and profits. However, if Fannie Mae and Freddie Mac are nationalized, then taxpayers share both the burden (liabilities) and the assets (mortgages) of the two giants; it is simply more equitable that way.
Nationalization is unlikely. The US government gave these two giants too much latitude, and someone (you and I) are being called to clean up the mess.
The arms of the speculation have a far reach; the bail out is now all but a foregone conclusion. Will Fannie Mae and Freddie Mac call in on the newly-extended lines of credit at the US Treasury in the upcoming week? What do you think?
Please leave comments. Best, Nontruths