With confidence waning at Fannie Mae and Freddie Mac, the US government has decided to step in and bail out the two beleaguered firms. The companies, known as government-sponsored enterprises, or GSEs, affect nearly half of the nation’s mortgages by either owning or guaranteeing them. More precisely, by issuing securities they provide liquidity to the mortgage markets. They make their money by charging a guarantee fee on loans this is has securitized into mortgage-backed securities.

Treasury Secretary Henry Paulson asked Congress for authority to buy unlimited stakes in and lend to the companies. This would also include increasing the credit lines for both firms.

Interestingly, this purchase in equity would be the first time ever that the US government has taken an equity position in either firm.

One of my main concerns at the moment is this: the US steps in to finance the bailout of these firms and serve as the backstop with at least $15 billion. However, by undertaking such a tremendous debt load, US bonds risk the possibility seeing their AAA credit ratings downgraded. While executives at most credit agencies deny a downgrade in the US rating even with the bailout, I wouldn’t be so certain. That was last week – this is this week. And we all know that this market has no memory from day-to-day.

Keep in mind that these firms engage the use of derivatives to “hedge” their cash flows. These derivatives include interest rate swaps and options to enter interest rate swaps. And recently, the value of these derivatives have been highly volatile therefore making it difficult to assess the underlying problems that may exist at these firms.

I would tread carefully around this news. I can see this matter maybe getting worse before it gets any better.

News pieces regarding the bailout:

Paulson Puts Treasury’s Weight Behind Fannie Mae, Freddie Mac [Bloomberg]

Treasury and Fed Pledge Aid for Ailing Mortgage Giants [WSJ.com]

Treasury Acts to Save Mortgage Giants [NY Times]

My expectation is that the US markets open higher on Monday based on this news.

Last 5 posts by Agustin Gonzalez

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