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Fannie Mae/Freddie Mac Death Watch

An Era Ends

About two weeks ago, I wrote in this space that some very large tectonic plates were starting to move far below sea level in the financial world. That was based on some unusual patterns I was seeing in the overnight repo and money markets.

I guessed (but had no information to confirm) that whatever was in the breeze had something to do with Fannie Mae and Freddie Mac, the pseudo-private corporations that together own or guarantee about half of all US mortgages, and today account for about 70% of newly-originated mortgages.

This weekend, there are many reports that Fannie and Freddie will have their managements and directors dismissed, their equity extinguished (or nearly so), and enter what’s called a government conservatorship.

In essence, the firms will be allowed to continue their current business operations, but under government control, and their shareholders will be wiped out.

The move is being spearheaded by Treasury Secretary Henry Paulson, and Ben Bernanke at the Fed has his hands all over it too. The structure and timing of this nearly-inevitable move have been the subject of intense speculation over the five weeks since Paulson asked Congress for, and received, unusually broad powers to take action with respect to Fannie and Freddie.

As we’ve come to expect, the action (which undoubtedly has been quietly but intensely debated all summer) should be complete by just before 7:00 PM tomorrow night, New York time. That’s when Asian markets open for trading on Monday morning, local time.

This is basically a good move. The US mortgage market has been de facto a creature of the federal government ever since Fannie Mae was created during the New Deal, and Freddie Mac in the late Sixties. The point of this is to get control over an extremely dangerous situation before it catches fire.

We’re seeing at least two critical things here that bear the hallmarks of Secretary Paulson (apart from the aggressiveness): First, the total willingness to destroy private shareholders in order to avoid moral hazard. We saw that in the Bear Stearns situation, and I applaud it.

Second, the willingness to use the government’s power to intervene forcefully in what theoretically are free markets.

There’s a very great deal more to say about this point. When we get closer to Sunday evening, I’ll post again and give you the deal details, and say more about the government’s new level of involvement in the financial system.

-Francis Cianfrocca

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