Forex

Taxpayers are still reeling from the thought of their money going to help JP Morgan (JPM: 33.16 0.00 0.00%) buy Bear Stearns. Both are companies whose senior executives have pocketed millions while the average Americans are seeing their net-worth squeezed on both sides by rising costs and falling home values. So why should the government step in to help Freddie Mac (FRE: 7.75 0.00 0.00%) and Fannie Mae (FNM: 10.25 0.00 0.00%)?

Both Freddie and Fannie are very privileged companies, they were created by the government, don’t have to pay federal or state taxes, and can borrow at rates that are nearly what the US government itself pays. They are also required to hold much less of a cash cushion than their competitors which gives them far greater leverage. Thanks to this - and extreme lobbying which has allowed them to maintain this privileged status - both of these companies have fattened to the point where they hold or guarantee more than $5 trillion in mortgage loans and owe nearly $1.6 trillion.

On the surface their business model is fairly simple, they buy loans from banks and other institutions which pay them a higher yield and then borrow at amazingly low rates, thus making money from the difference between what a borrower pays in interest for their house and what they pay in interest for the loans they service. There is of course the pesky little risk of default they have to take into consideration, but as long as that is within their calculated margin, they can turn a hefty profit.

Over the past week, the fear that perhaps the amount of defaults will increase to a level where they will be unable to service their own loan obligations thus leaving them insolvent ,has pushed both of their stocks down by nearly 50%. On Monday, we’ll see if the fears have spread into the money markets as Freddie tries to raise $3 billion from there.

Freddie and Fannie have always enjoyed such low rates on the money markets as there was an “implicit guarantee” that they would be supported by the US government if they ever needed it. Up until recently the government has denied that, but it has now been discussing stepping in and “hardening” that guarantee.

Let’s imagine for a moment that the government doesn’t step in and help them.

The first thing to happen would be that the money market’s iron-clad trust in Freddie and Fannie would disappear in the blink of an eye and it would be impossible for these companies to get loans at rates which would make sense for their business. Since they would be unable to get loans, they would stop buying mortgages and mortgage liquidity would dry up across the board.

Suddenly very few loans would be on offer and buying a house would require a sizeable amount of cash. This would put the housing market into a freefall and with it would go the economy and of course the stock markets. If that were to happen, Freddie and Fannie would find they are holding a lot of worthless paper and would be unable to service their $1.6 trillion in loans to banks, pension funds, mutual funds, sovereign funds and other countries who bought these securities. And just like that, the house of cards which is the US financial system built purely on trust would come tumbling down.

Government stepping in to help…with your money

No one wants to see that situation come into effect, so once again, you, the taxpayer, will be footing the bill while the executives get away with their fat earnings. But just how big will that bill be? It depends what exactly the government does.

The Bush administration is asking Congress for permission to buy billions of Freddie and Fannie stocks and give these companies any loans they need. As a taxpayer, there is that nagging question of why the government is using our hard-earned cash to buy shares in these companies? Sure, the effects of them failing are probably far worse, but is that really the best way forward? On Sunday, the Federal Reserve has voted to open an emergency lending facility for these two companies to give them access to capital while posting their own securities as collateral. So in the end, the government is going to be exchanging your tax money for securities of struggling companies.

These initiatives are bound to inspire at least some confidence in the short-term and their stocks should get a lift. But how long can the Fed and the government keep the confidence flowing as the market continues deeper into bear territory? As it stands, confidence is in short supply, and fiascos like Bear Stearns saying it had enough capital shortly before its collapse are still very fresh in investors’ minds. So when these two companies say they have “adequate capital” even as both the government and the Fed work on emergency measures.