Fan/Fred I Are Dead: Long Live Fan/Fred II!

Why is it that they always drop the bomb after the close on a Friday? That’s what the panel of Fox Business’ “Bulls and Bears” noted during a commercial Friday at about 4:15 pm, after Wall Street Journal writer Deborah Solomon joined us after breaking the story of the government bail-out of Fannie Mae and Freddie Mac.

I opined that the “on-the-record” rationale was that the parties involved needed a weekend to iron out the details (as if they have not been working on this massive endeavor for months!), while the not-so-subtle benefit was that the news would make the hedge funds crazy and potentially cost them some money. Regardless of the timing, the group agreed that action was necessary, if not wholly desired on an intellectual level.

At the time of this writing (Saturday afternoon), the details of the plan were not fully known, but it is believed that the US government is about to make its backing of mortgage giants Fannie Mae and Freddie Mac from implicit to explicit. According to people briefed on the secret discussions, the companies are likely to be into government conservatorship of their regulator, the Federal Housing Finance Agency; the current executives and boards of the two companies will be replaced; common stockholders (and potentially preferred shareholders) would be virtually wiped out; and the companies will continue to function because the government will now be standing behind the debt on their balance sheets. In essence, the government will temporarily run the companies, probably by injecting capital on a quarter-by-quarter basis.

For those who thought the government’s role in Bear Sterns was a big deal, fasten your seatbelts—according to Solomon, this “would represent perhaps the most significant intervention by the government in the financial industry since the housing bust touched off turmoil in the credit markets a little more than a year ago.” This makes everyone seethe, including me. But once the barn door was open on the situation, I am not sure what the alternative could have been. After all, Fannie and Freddie own or guarantee more than $5 trillion of mortgages and given the state of the already depleted housing market (Fan/Fred are now responsible for nearly 70% of new loans), it was simply untenable to allow them to fail and for the mortgage market to completely seize up.

Treasury Secretary Paulson knew as much, which is why he sought and eventually gained the authority to intervene in the two companies at the height of fear in July. Since then, federal officials have been working with bankers at Morgan Stanley (they are only charging Uncle Sam for overhead, not their customary consulting fees) to figure out how to untangle the mess. The answer is now becoming clearer— Fan/Fred will continue to operate as the government cleans up and restores their balance sheets. How do we all participate in this fiasco? Well, US taxpayers will be on the hook for the huge potential liabilities of the companies, which some estimate to be somewhere in the $40-$50 billion range. This is why we should invoke the old English mantra: Fan/Fred I Are Dead: Long Live Fan/Fred II!