Saturday, September 06, 2008

Government to take over Fannie Mae and Freddy Mac; Credit crisis continues

Friday the officials from the Bush Treasury and the Federal Reserve informed the top executives of Fannie Mae and Freddie Mac that the government was taking them over. It a move that will wipe out the shareholders and replace the top executives and Boards of Directors of the two struggling institutions, the Federal government will place both into conservatorship. Both companies will continue to function, with the government guaranteeing their debt.

The declining housing and real estate markets have continued to erode the balance sheets of Fannie Mae and Freddie Mac with the loan losses no longer limited to subprime mortgages. This action by the government is required because the losses suffered in the Mortgage market continue and the Fannie Maw and Freddie Mac are no longer able to deal with those losses without government guarantees. More loan losses are expected in the future so that the weakened balance sheets threaten the continued existence of the two firms. The erosion of the balance sheets have so weakened the firms that foreign governments have become extremely antsy about holding debt issued by the two institutions.

Since together Fannie Mae and Freddie Mac guarantee 70% of American mortgages, the two institutions must continue to function or the American housing market will cease to function. Since the two firms are finding that they can no longer raise the capital needed to continue to operate, the only solution is for the government to take them over and guarantee their loans. This action will permit the mortgage markets in the US to continue functioning, at the cost of making formal previously stated guarantees by government officials that the taxpayers will guarantee the securities issued to the two firms. This makes official the implied exposure of taxpayers to the large potential future losses.

The two companies will continue to operate as they have previously, buying up mortgages, packaging them into securities and selling the securities to obtain new funds to allow the purchase of more mortgages. Since the government has been telling foreign governments that the US government already stands behind the securities sold by Fannie Mae and Freddie Mac, this move essentially makes the guarantees made by the US government official.

It is expected that ultimately the two companies will be broken up into smaller institutions which are not “too large to fail” and sold off to private investors.

From the New York Times.

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