Freddie, Fannie and Implicit Federal Guarantees

Freddie Mac and Fannie Mae have, between them, the worst of jobs in this particular market: making the mortgage loans that every other bank is running away from ...fast. Between these two companies, they guarantee about $12 trillion in loans. Yes, that's a 't'. What's curious about the current situation, however, is that although these two companies have the implicit guarantee of the federal government, the open market seems to have placed some question on whether that federal government would actually step-up when the time comes... as it may very well come.

Today, there's even a question of the companies' solvency. Solvency, as you know, represents a company's ability to repay all its creditors after liquidating all its assets. Consequently, there seems to be some question as to whether the assets of Freddie and Fannie actually outweigh the massive debts it now holds. Of course, with a guarantee from the Federal government, there would be no worry as the government could always, theoretically, print money to pay every one back. With the staggering sums at stake, however, some are questioning whether they will do so. How do we know that they're questioning this? Simple. Look at the premium that Freddie Mac just paid on its latest $3 billion debt issue - almost 3-quarters of a percent over the U.S. Treasury rate. That premium is a risk premium, of course.

One could, of course, take the opposite position on this and reap the rewards should the market have overreacted. The consequences of allowing Freddie and Fannie fail would overwhelm anything that could have happened from the failure of an investment bank such as Bears Strean, which the Fed has obviously stated could not fail. Similarly, then, Freddie and Fannie cannot fail. As such, the markets certainly appear to have seriously overreacted on their risk asssessment of these two companies. An investor prepared to take this leap of faith, however, could benefit from a staggering medium-term return should the Fed make its implicit guarantee explicit. So, where do you stand?