Fannie and Freddie Take Down The One Day Bull Market.

Good evening!

That rally sure didn't last long. I was surprised by the violent reversal today. The Federal pump lasted exactly one day. The market is starting to say "heard this one before" as they continue to dump stocks.

The Fed is beginning to lose all credibility because all they do is talk and talk and talk. When it comes to taking action like raising rates to strengthen the dollar or exposing the banks balance sheets, they bury their head in the sand and do NOTHING. They are all bark and no bite! Hmm how else can i put it. Remember the little boy who cried wolf?

The drop today IMO is all about the three F's. Fannie, Freddie, and fear.

The market sent a strong message to the powers that be today. They listened to these grand speeches by the pigmen and the Fed yesterday and reacted by coughing "bull****" as the government told us everything is going to be just fine with the economy and housing.

A Notice from me!

From here on out, I consider Fannie and Freddie to be the housing market. Anytime you see these words on this blog think "the housing market". I say this because they are the only ones doing loans and they own most of the bad debt.

This is what housing has morphed into folks. Housing is guaranteed by two GSE's. What happens to these entities will eventually tell you what will happen to housing. Follow these two companies every move if you are looking for forward looking indicators as to what happens to the housing bubble.

Derivatives traders lower their own credit ratings on Fannie/Freddie

Here is where the trouble for the markets started today. Remember the part where they told us Fannie and Freddie were in strong shape and had the full support of the government? Well by midnight, here is what derivative traders thought of this arguement:

"July 9 (Bloomberg) -- Fannie Mae and Freddie Mac, ranked Aaa by the world's largest credit-rating companies, are being treated by derivatives traders as if they are rated five levels lower.

Credit-default swaps tied to $1.45 trillion of debt sold by the two biggest U.S. mortgage-finance companies are trading at levels that imply the bonds should be rated A2 by Moody's Investors Service, according to data compiled by the firm's credit strategy group. The price of contracts used to speculate on the creditworthiness of Fannie Mae and Freddie Mac and to protect against a default doubled in the past two months.

Traders are overlooking the government's implied guarantee of the debt as credit losses grow and concern rises that the companies don't have enough capital to weather the biggest housing slump since the Great Depression. Washington-based Fannie Mae fell 73 percent in the past year on the New York Stock Exchange and McLean, Virginia-based Freddie Mac lost 60 percent of its market value.

``Investors are viewing even an implicit guarantee from the government as potentially troublesome,'' said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California."

Quick Take:

Gulp! In a nutshell, traders don't believe the government is willing to take on the $5.3 trillion in debt that Fannie and Freddie have piled up. This would double the government's debt and the government is not obligated by law to do this. As a result, these companies are being treated like any other financial firm. Bad companies get bad credit ratings.


What if Fannie and Freddie Failed(a must read)?

Here is a great piece on what would happen if they failed, along with the most likely scenarios of how this will all play out.

Here is the problem these two firms face:

"If Fannie or Freddie failed, it would be far worse than the fall of [investment bank] Bear Stearns," says Sean Egan, head of credit ratings firm Egan Jones. "It could throw the economy into depression or something close to it."

Clearly, investors remain concerned. Credit default swaps - a kind of insurance against the possibility of Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500) defaulting on their corporate bonds, are at their most expensive levels in 14 weeks; both companies are expected to report steep losses for the second quarter; and their main business, mortgage securitization, is under pressure as home price values decline and foreclosure numbers rise.

"The major issue is that these are very leveraged financial institutions, leveraged much more than any other bank, and they have lots of mortgage assets. As real estate values decline every day, the value of [the mortgages that it bundles, guarantees, and sells] are called into question," says Dalton Investments co-founder Steve Persky, who has been focused on distressed mortgage assets.

The possibility of government aid looms because it's hard to see how the private market can help the companies. Their stock market values have dropped so low that it would be difficult for them to raise money. For example, Egan estimates that Freddie alone will need to raise $7 billion over the next two quarters due to writedowns and losses. But the company's market capitalization - the number of outstanding shares times the share price stands at $8.7 billion."

Quick Take:

Would you lend these clowns any money? I wouldn't give them a dime unless I expected it to be a donation.

Back to the Piece.

So with an inability to raise capital what are the likely scenarios on how this plays out:

"The disaster scenarios

The Federal Reserve and the Treasury have taken great pains to point out that the government is not obligated to bail out either Fannie or Freddie if they face insolvency. It's debatable where the legal obligations lie, but as a practical matter, the government can't let these institutions fail because they are being counted up on to help fix the mortgage mess. If Fannie and Freddie were unable to buy and back loans, banks would stop originating them and the pool of homebuyers would shrink, causing home prices to fall even further.

Fannie and Freddie must constantly borrow money in order to operate; if for any reason borrowing costs rose sharply they would not be able to make good on their guarantees or even fund their day to day operations. This is when the government would feel intense pressure to step in and, at the very least, pay contracts in a timely manner.

In an April report, Standard & Poor's said an Armageddon scenario whereby Fannie and Freddie are insolvent is unlikely, but that the mere possibility of failure at either is a greater threat to the economy than the actual collapse of any investment bank."

The bailout scenarios

So what might it look like if the government had to lend a hand? Outright nationalization is an unlikely option given that neither the current administration nor the presidential candidates could afford to support such a move in an election year.

More likely, the Treasury Department or the Federal Reserve would come in and provide a liquidity backstop, in the form of a loan or guarantee to bondholders that they will be paid. Fannie and Freddie could even do a preferred stock deal with the government, much like the deal forged by Citigroup with the Abu Dhabi Investment Authority, says Egan.

That would allow give officials the ability to argue that they weren't bailing out the companies, but rather making an investment that would pay off in the long run.

Mason has a diffferent twist on a possible intervention. If either were to face insolvency, he says the government should purchase a large voting block of equity in the institution and use that as a tool to eliminate any dividends, replace officers and manage the firms back to solvency.

"But [a rescue] would be a political situation, so it would be messy," says Mason. "Fannie and Freddie would fight against having officers replaced. They would want to keep the dividend."

The doomsday scenario could cost taxpayers more than $1 trillion, says the S&P report. The report went so far as to say that a government bailout of Fannie or Freddie could force the agency to lower its rating on the creditworthiness of the United States."

Final Take:

As you can see there are no good options. The reason the traders are killing Fannie and Freddie's debt ratings is because these two will not be saved BEFORE they drown in their own debt. This makes them potential zero's in the stock market.

There is no way the government is going to take on $5 trillion of inflated, bloated "bubble debt". They will sit tight and wait for both companies to self destruct. Billions of dollars of "bubble debt" will be defaulted on and wiped clean while they wait which will make things much easier on the Fed's balance sheet.

This is when we will see the sticksave from the Fed. Intervening early and backstopping the $5 trillion of debt that these two ponzi machines ran up simply makes no sense. Sweden waited for a 50% correction in housing pricess during their housing bubble before their government intervened.

The sad thing here is who do you think finally ends up paying for this? Go take a look in the mirror.