Friday, July 11, 2008

 

Fannie and Freddie have already failed

The shares of Fannie Mae and Freddie Mac are down about 45% this morning in pre-market trading on the gov'ts signaling that they are considering a bailout of both mortgage originators. They better hurry because both companies equity is vanishing at an incredible rate and there is a real danger that the rumor of failure is enough to push them over the edge.

However, this is not an easy decision despite Maverick's bold call to save them on the taxpayers dime. For the federal gov't to take on both financial companies balance sheets means about taking on $5 trillion in iffy mortgage-backed securities.

To put that in perspective, consider that total U.S. federal debt is about $9.5 trillion, compared to a total U.S. GDP of $14 trillion. About $5.3 trillion of that debt is held by the public (in the form of Treasury bonds and the like), while $4.2 trillion is intragovernment debt such as Social Security IOUs. This is the liability side of America's federal balance sheet, and its condition influences how much the government can borrow and at what rates.

The liabilities of Fan and Fred are currently not on this U.S. balance sheet. But one danger is a run on the debt of either company, putting pressure on the Treasury and Federal Reserve to publicly guarantee that debt to prevent a systemic financial collapse. In an instant, what has long been an implicit taxpayer guarantee for both companies would be made explicit – committing American taxpayers to honoring as much as $5 trillion in new liabilities. U.S. debt held by the public would more than double, and the national balance sheet would look very ugly.

So all the gov't can do is slow the process by taking on these liabilities. If they did they would spread the risk over the entire gov't and, this is very important, put into doubt the solvency of the the U.S. I say it is better to let Fannie and Freddie fail than to risk the AAA rating of the United States. This would be one hell of a gamble and I just don't think it is worth it.

Be very, very careful.

Update: The 10 year U.S. treasury is down 4/32nds despite the stock markets being down 1.5%. This is proof that the market is worried about the effect of a bailout. I repeat, we should never mess with the credit rating of our country.

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