freddiemac.thumbnail.gifI will manfully resist saying "I told you s…", er, in response to this Friday news dump:

The government has formulated a plan to put troubled mortgage giants Fannie Mae and Freddie Mac under federal control, dismiss their top executives, and use government funds to prop them up…

Under the plan, the federal government would place the firms in a legal state known as conservatorship, the sources said. The value of the company’s common stock would be diluted but not wiped out while the holdings of other securities, including company debt and preferred shares, would be protected by the government.

Details are scarce, my best guess based on past musing is that they will issue preferred stock that the government will buy as their means of putting money into the two companies. Because that stock will have preference over common shares, the value of common shares will plummet, but not be wiped out. Debtors won’t lose a cent, probably intended to avoid a cascade of credit swaps, as Morgenson pointed out. The original plan was to also wipe out preferred shares by making the new shares senior even to them, it looks like Paulson blinked on that.

This was probably necessary, and all the happy talk about how the cost of the bailout would only be 5 to 25 billion should now be seen as being as empty as it always was. If the bailout was only going to be 25 billion, this wouldn’t be happening.

From a public policy point of view this is a bad way of doing something that’s necessary. There’s no particular reason why preferred shareholders shouldn’t be wiped out along with common shareholders – owners of companies that go belly up should lose everything. Likewise, men like Pimco’s Bill Gross made big bets by piling into Freddie and Fannie’s debt in the expectation of a government bailout, when they knew that the debt was bad if the government didn’t bail Freddie and Fannie out, and they are going to win those bets. Again, when normal companies go belly up, debtors don’t get all their money up and one shouldn’t be rewarding men who deliberately bought debt they knew was bad. Going into conservatorship is the equivalent of going belly up. Bondholders should take a haircut—they shouldn’t lose everything, but they should certainly lose whatever they would have lost if Freddie and Fannie had been allowed to go bankrupt like normal companies. To not do so is a clear case of moral risk; a clear case of bailing investors out of their own bad decisions; and a clear case of shifting money from taxpayers to private interests.

Or, in other words, privatize the profits, socialize the risk.

Obviously, as Ishmael pointed out, bondholders (many of whom are foreign governments who are very unhappy about what is happening to their US holdings) put the pressure on, hard, and Treasury has folded.


Freddie and Fannie had to be bailed out, don’t get me wrong, but this is about the worst way of doing it if your idea was to avoid moral risk and to protect the taxpayer’s pocketbook, rather than those of investors.

I am also amused by two other items—first that they are going to dribble the money in in bits, rather than ponying up soon: Paulson "I won’t be around when the real bill hits. Phew!"

And second, this:

Executives of the two companies were told to show up without being told of an agenda. Daniel Mudd, chief executive of Fannie Mae, was accompanied by outside lawyers.

Yeah… these guys know they were negligent at best. If I were Mudd, I’d keep lawyering up.

I will maintain my prediction that when all the costs are added up, years from now, the total bill will come to close to half a trillion.