A.

First of all, who are Fannie Mae and Freddie Mac?

Fannie Mae: Is the nickname for the Federal National Mortgage Association

and

Freddie Mac: Is the nickname for the Federal Home Mortgage corporation

Collectively, they are know as GSEs or Government Sponsored Enterprises and their job is to provide local banks and mortgage lenders with liquidity to finance home mortgages.

These GSEs are not government owned, only government sponsored. This means that they are privately held and operated by shareholders but receive a line of credit from the US Treasury and an exemption from taxes. Fannie was privatized by Lyndon B. Johnson in 1968 to remove it from the national budget. Freddie was created in 1970 to prevent monopolization of the secondary mortgage market by Fannie. Both GSEs are exempt from SEC oversight.

Fannie Mae and Freddie Mac are very important entities within the US economy. They guarantee approximately $US 6 trillion in outstanding home loans and service 50 million mortgage customers. The value of their loans is equal to 2/3 of the current national debt!

With a triple A credit rating and a $2.5 billion credit line with the Treasury, many investors have long considered Fannie and Freddie the safest of the safe.

B.

So What’s the Problem?

As owners of the lion share of mortgages, Fannie and Freddie have not been immune to the subprime mortgage crisis. However unlike the other Fortune 500 companies, Fannie and Freddie are not forced to disclose their financial difficulties. Investors fear that they will suffer more losses than the $11 billion that has already been reported.

Not too long ago, the Justice Department and the SEC discovered accounting errors in the amount of 4.5 to 4.7 billion dollars. The current fear is that the sheer size of Fannie and Freddie’s potential losses eclipses their lifeline.

Fannie and Freddie’s shares have fallen to the lowest levels in 19 years. Speculators believe that not only could they be insolvent, but based upon the comments from US Treasury Secretary Paulson and President Bush, the US government does not think that a bailout is needed.

Yet liquidity problems can be compounded by market fears. Remember how Bear Stearns’ credit lines were all pulled on speculation that the bank would go under, which of course exacerbated their demise. Selling of government bonds can lead to higher bond yields and pricier borrowing costs for the GSEs.

C.

Too Big to Fail?

The biggest question in the financial markets right now is whether or not Fannie and Freddie are too big to fail? I certainly think so. If the government stepped in to prevent the Bear Stearns meltdown from crushing the market, they will step in to prevent a collapse in Fannie Mae and Freddie Mac because if these 2 GSEs fail, Americans will have to shoulder the burden. Fed Chairman Ben Bernanke has already announced that the GSEs can have access to the discount window, which would allow them to borrow money directly from the Federal Reserve rather than the markets.

Bernanke Opens the Discount Window, But Will that Be Enough?

If Fannie and Freddie’s problems are not solved and they still have difficulties borrowing, this means that they will have difficulties lending, which is something that the US government can not gamble with at this moment.

It would send a much stronger mess to the markets if the US government:

1. Guaranteed Fannie and Freddie’s Loans
2. Nationalized the GSEs
3. Infused Government Funds into Fannie and Freddie (Equity Investment)
4. Encourage Further Investments from Private Investors

China, Japan, the Cayman Islands, Luxembourg and Belgium are the top 5 foreign holders of Fannie and Freddie’s debt.

For the currency market, it is a lose-lose situation for the US dollar. Further problems at Fannie and Freddie would push stocks lower once again, which would trigger another flight to safety out of US dollars. A bailout would essentially double the public debt, risking a downgrade in the US credit rating.