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Government to Wipe Out Fannie/Freddie Shareholders by Sunday

06/09/08 --"Weblogs"- And now what could become history's biggest transfer of tax dollars to bail out bad lending begins. Last month Congress passed a bill that gave the Treasury Department $800 billion to bail out Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). And while it is unclear how much money will be used to bail them out, the general outlines of the soon-to-be-announced terms are becoming clearer than they were last night.

The New York Times and The Washington Post report on five key features as follows:

  • Government bankruptcy. Fannie and Freddie will be taken under a conservatorship -- which is similar to a bankruptcy wherein a trustee operates the company so it can be fixed and ultimately sold back to public investors. The bailout would reduce the value of their common and preferred shares "to little or nothing," according to the Times.
  • Taxpayers bailout defaulted mortgages. Some share of the $800 billion in taxpayer funds will be used to pay "any losses on mortgages [Fannie and Freddie] own or guarantee," according to the Times.
  • Payouts on a quarterly basis depending on reported results. Treasury is trying to dribble the bailout over time. "Instead of giving each company a big capital infusion up front, the government could make quarterly injections as the companies' losses warrant. This would be an attempt to minimize the initial cost of the rescue," according to the Washington Post.
  • Fire CEOs and replace the boards. At a meeting earlier in the week, on which I posted, Daniel Mudd, Fannie's CEO, and Richard Syron, Freddie's CEO, "were told that they would have to leave. [And] the companies boards would be replaced," according to the Times. I can only imagine the firestorm that will ensue if Syron gets another $38 million as a severance package.
  • Announce deal before Asian markets open. As it did with the Bear Stearns bailout, the government caters to Asian markets so it "had been planning to announce the decision as early as Sunday, before the Asian markets reopen," according to the Times -- as I thought yesterday.

Why did Paulson decide on this bailout? His bazooka strategy -- merely having the authority to bail out the two companies -- did not alleviate investor anxiety. He measured that by the widening interest rate difference between Treasury and Fannie- and Freddie-backed securities. And concluded that in order to lower that spread and bring down mortgage rates he would need to use his bazooka rather than merely keeping it in his pocket.

When it was announced in May 2006 that Paulson would take over as Treasury Secretary, I speculated that he did so because he thought he would have a bigger challenge than Robert Rubin -- another Goldman Sachs Group (NYSE: GS) alum -- in cleaning up the coming financial catastrophe created by our dependence on foreign ownership of U.S. debt. And I thought Paulson would try to make his name in the history books by dealing with that cleanup.

It remains to be seen how history will judge him -- but since China owns $340 billion of Fannie and Freddie mortgage-backed securities -- it looks like my guess about the first part was partially right.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.

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