Monday, September 08, 2008

Fannie Mae and Freddie Mac Quick Analysis

What does the seizure of Fannie Mae and Freddie Mac really mean? Here are some quick thoughts...

If any of you were under the illusion that we live in a free market economy, this should be the nail in the coffin. Free markets don't step in and save struggling companies. They let them die and use the corpses as reminders to other companies to make smarter decisions.

But no, not us. We encourage bad behaviour and fiscal irresponsibility by stepping in to save companies that could not survive on their own.

5cr3w the Taxpayer
I have a business proposition for you. I will start a company. If I make money, I will keep all the profit. BUT, if I LOSE MONEY, then you will assume my debts. Sound good?

Well, that's exactly what is happening to us right now with this seizure. Fannie and Freddie were private companies. That means that they lent the money privately, and kept the profits privately.

But now they are in trouble and the GOVERNMENT has taken over. That means that Johnny and Sue Taxpayer, You and I, are now responsible for the debts incurred by these irresponsible companies.

Read it again, I am not making it up: They have a business. They make money. They keep it. They lose money, now its our responsibility and we pay for it.

Bondholders Win
The takeover shelters bondholders while potentially hurting stockholders. Considering the influence that bond holders have over fiscal and monetary issues, especially the valuation of currency, this is a very interesting area that I'd like to look at more later.

However, in the near term, this take over bodes well for bondholders at the expense of stockholders.

Smaller Banks In Bigger Trouble Now
Let's look at the stockholder / bond holder thing in more depth. Bond holders own debt in a company. Companies sell bonds and promise to pay the money back later. A bond is like an IOU.

Stockholders own shares in a company. If the company goes up in value, the value of their shares go up, making them money. They also get paid money in the form of a dividend.

Simple stuff.

Okay, so, let's look at what happens. If these companies fail, they can't pay back their debts and the stock is worth nothing. So, everybody loses their money.

On the other hand, with this take over, the stocks lose value and the dividends get eiliminated, but the companies still exist, so they can pay back their debts. So, the stock holders lose, but the bond holders win.

Now, the question is, who are the stock holders?

In particular, a lot of banks held shares in these companies. But, these banks are now faced with holding a lot of paper worth a whole lot of nothing. Worse, the dividends that the stocks were going to pay have probably been completely lost.

It's a lot like people who live month to month finding out that they won't be getting a paycheck next week.

So, even though we have been expecting bank failures en masse (See the Bank Closure Map), the exact mechanisms on how they would happen were unclear. But, with the seizure of Fannie Mae and Freddie Mac, very clear lines are now drawn for many more banks to go under.