What If Fannie and Freddie Fail?

Includes: FMCC, FNMA
by: Ron Haruni

Freddie Mac (FRE) and Fannie Mae (FNM) - both government sponsored enterprises - fell to the lowest levels in more than 12 years during the course of this week’s trading. The PPS - dump, on both tickers, came amid concerns that the two largest U.S. mortgage-finance companies may need to raise more capital. According to a Lehman Brother analyst, Fannie Mae would need to add $46 billion of capital while Freddie Mac would need approximately $29 billion.

On Wednesday, Fortune ran an article entitled 'The Fannie and Freddie doomsday scenario'. The article alludes to the premise of what would happened if both  enterprises failed. The article also offers a bailout scenario:

Here’s a scary, and relevant, question to ponder as the housing market continues to slide: What would it take for the government to step in and help Fannie Mae and Freddie Mac, and how would a rescue affect you, the taxpayer?
“If Fannie or Freddie failed, it would be far worse than the fall of [investment bank] Bear Stearns,” says Sean Egan, head of credit ratings firm Egan Jones. “It could throw the economy into depression or something close to it.”

Since both companies play not only a critical and essential role in the market, but also a stabilizing one for the sector in particular and the economy in general, I don’t see how the Treasury or the Fed can realistically afford to show negligence around such a dire situation (if it were to get to that level that is). The doomsday scenario, notes the article - could cost taxpayers more than $1 trillion:

More likely, the Treasury Department or the Federal Reserve would come in and provide a liquidity backstop, in the form of a loan or guarantee to bondholders that they will be paid. Fannie and Freddie could even do a preferred stock deal with the government, much like the deal forged by Citigroup with the Abu Dhabi Investment Authority, says Egan....

In an April report, Standard & Poor’s said an Armageddon scenario whereby Fannie and Freddie are insolvent is unlikely, but that the mere possibility of failure at either is a greater threat to the economy than the actual collapse of any investment bank.

Investors remain understandably skeptical and confused. On Tuesday, James Lockhart, [Via: CNBC] director of the Office of Federal Housing Enterprise, which regulates the two enterprises - said “Fannie Mae and Freddie Mac are adequately capitalized and continue to be active in the mortgage market”.

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