Bailout Nation to the Rescue

I'm sure by now you've heard that the United Soviets of America have decided to throw taxpayer money behind the nations biggest hedge funds Fannie Mae and Freddie Mac. There is a multitude of article onlines if you wish to dig through the details. I'll just offer a couple paragraphs from John Hussman who sums up well my feelings on the subject.

With that January 2009 “sunset” provision now gone, I expect that U.S. taxpayers will be on the hook for about $250 billion in losses. Look – 9.16% of U.S. mortgages are already delinquent or in foreclosure, with the likelihood of further delinquencies and foreclosures in the coming quarters. On a $5.2 trillion book of mortgage loans between Fannie and Freddie, and a prevailing recovery rate of 50% on foreclosed properties, an overall loss of about 5% of this book, or about $250 billion, is a fairly conservative expectation.

It's likely that the market will take some initial comfort from this transaction, on the notion that the government has provided a “safety net” under the U.S. financial system. The problem with that interpretation, however, is that Fannie and Freddie always had the implicit backing of the government, and the government is now being forced to save these institutions because private investors have increasingly refused to provide additional capital. Unfortunately, what is true of Fannie and Freddie is most likely also true of other financial institutions that do not enjoy the implicit backing of the government. The prospect of a government bailout of those other institutions isn't at all clear. So by essentially capitulating that Fannie and Freddie have to be taken over, the government is also sending a signal that other financial institutions (particularly investment banks with high gross leverage multiples) may be vulnerable to failure. For that reason, any “knee jerk” enthusiasm about this transaction will probably be misplaced.