Monday, September 8, 2008

Fannie and Freddie, Part 1

Yesterday the Federal government took the unprecedented step of placing Fannie Mae and Freddie Mac into conservatorship. The fate of Fannie and Freddie is no small matter: "[Treasury Secretary Henry] Paulson noted that more than $5 trillion of debt and mortgage-backed securities issued by Fannie and Freddie is owned by central banks and other investors world-wide. 'Failure of either of them would cause great turmoil in our financial markets here at home and around the globe,' Mr. Paulson said." (source: WSJ article)

What is a conservatorship? It means the Federal government has taken over management of the companies. Dividends and rights of ownership for stockholders have been suspended. Common stock and preferred stock remain outstanding, but it is unclear if they have any value. Directors and the two CEOs have been removed. With financial assistance from the U.S. Treasury, interest and principal payments on debt continue, including both senior debt and subordinated debt. The companies are not being liquidated, but will likely shrink in size. (more info)

Financial institutions in the U.S. have historically been regulated by the government, but not actually operated by the government. This action is "one of the most sweeping government interventions in private financial markets in decades." (source: WaPo article) The U.S. taxpayer is now liable for the payment of the $5 trillion in debt mentioned in the first paragraph. For reference, the annual gross domestic product of the U.S. was $14 trillion in 2007 (source) and the U.S. national debt is $10 trillion (source). The ultimate cost to the U.S. taxpayer will not be anywhere near $5 trillion. The debt is backed by U.S. home mortgages, and so the ultimate cost will depend on the value of those mortgages, which is presently unknown. The cost could easily be in the hundreds of billions of dollars.

This post is part 1 of 2. Click here for part 2.