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How Fannie and Freddie will fail September 20, 2008

Posted by frewon9 in News.
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Henry Paulson is maneuvering himself into the history books by forcing Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) into a spiral of doom from which they can’t recover. He had plenty of help from the directors and executives who sit atop them. But it’s becoming clear that since Saturday’s Barron’s article, laying out the path to failure, events are spiraling out of Fannie and Freddie’s control.

The anonymous senior government source in the Barron’s article said that unless Fannie and Freddie could raise at least $10 billion each, the government would bail them out while wiping out common shareholders and eliminating the preferred dividend. This would lead to a sell off of bad loans, a split into smaller pieces, and maybe selling those pieces back to the public. All these activities are a government gift to Wall Street, which will get to do all these deals.

Events are following this predicted pattern as Fannie and Freddie struggle to raise capital. The New York Times reports that investors are not enthusiastic about the most recent efforts to raise capital by Freddie Mac. It reports that on Tuesday, Freddie Mac raised $3 billion in five-year debt but the “1.13 percentage points [premium] over the rate the federal government pays for comparable borrowing” was more than double the “0.6 points” premium it paid earlier in the year.

As their higher debt costs become common knowledge, fewer investors will show up to buy their debt and their borrowing costs will become prohibitively high. Nor can they issue common equity because as their share prices drop on news of their financing problems, the massive number of shares they would need to issue to raise meaningful amounts of capital would severely dilute existing common shareholders. And as their costs of borrowing rise, they will need to pass those higher costs onto people seeking mortgages, which will put further downward pressure on housing prices.

Just as Bear Stearns did, Fannie and Freddie may not be able to obtain the short-term financing they need to continue to operate. Bloomberg News reports that their ability to roll-over — exchange for new notes — by the end of September their $223 billion worth of notes will soon test whether Fannie and Freddie suffer Bear’s fate. To be sure, Bear failed when holders of its overnight repos — nightly loans backed by securities — refused to roll them over for Bear.

While the Fannie and Freddie notes in question are longer term than repos, the concept is the same. In a recent case, the holders of that short-term debt were Asian investors who are getting less and less enthusiastic about owning Fannie and Freddie securities. Bloomberg reports that Asian Investors bought far less of the recent $3.5 billion Fannie offering — 22% — which is “almost half the demand of three months ago and about two-thirds of Asia’s usual purchases.”

Unless the U.S. government steps in to explicitly guarantee those notes, Fannie and Freddie could soon hold an offering for their short-term debt and nobody will show up.

And that’s how Fannie and Freddie will fail.

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