The Great GSE Meltdown: Market Adding Fuel to Fire?

Includes: C, FMCC, FNMA, GE, LEH, MER
by: Wall Street Weather

As I write this, CNBC (NYSE:GE) with Jim Cramer, The New York Times, and the “no comment” White House appear to be doing their best to add fuel to the fire of creating a major financial meltdown through the government-sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE).

It is clear to me what the players are attempting to do. The Bush Administration wants to show they’ve got the guts to implement moral hazard by allowing at least one regional bank to fail. Both political parties are angry that the GSEs are not raising more capital. Wall Street is attempting to make up for all their losses through shorting most of the financial sector, the media wants to boost their ratings, and Cramer and former* St. Louis Federal Reserve Bank president William Poole are looking to boost their own star power.

They should all be careful what they wish for. Think about the implications of little or no stock value in the GSEs. These people are in essence telling investors that the moral hazard lesson is to “stay away from equity in financial companies.” This will totally impair the ability for Citigroup (NYSE:C), Merrill Lynch (MER), and Lehman Brothers (LEH) to raise capital. What the government is implying is that major financial institutions will have to shrink their balance sheets rather than expanding credit. At that point there will be no winners in this game.

*William Poole retired from the Fed on March 31, 2008. He will take up his position as scholar in residence at the University of Delaware, Conrado (Bobby) M. Gempesaw, dean of the Lerner College of Business and Economics, this Fall.

Disclosure: I just bought FNM, FRE. Long C.