Freddie and Fannie were two Americans most Australians never knew existed until recently. Freddie and Fannie are two large US institutions that perform the function primarily of selling mortgage insurance against US housing mortgages. They do other things (see Wiki)
Fred and Fannie are very highly leveraged. In fact it ought to be a criminal offense for anyone to be leveraged at 140:1 (debt to common stock) :-). They could only get to be so large because there was always an implicit US government guarantee supporting this caper. Invaribly, when moral hazard comes into the picture, it usually ends in tears. The reason it’s ending in tears is the state of the US housing market has essentially rendered these two insolvent. Insolvency could mean US$5 trillion which would be the big enchilada of all time.
Enter Bill Ackman a well-known Hedge Fund manager who’s come up with what seems to be a truly brilliant proposal to save the US taxpayer a lot of money, keep these two institutions solvent and finally allow the US government to remove its implicit guarantee. The proposal, if it goes through, would probably cost the US government nothing and allow the two newly well-capitalized institutions to continue doing what they do, which is to insure mortgages in a far more conservative real estate market environment.
Ackman’s plan is as follows:
1. Wipe out the common shareholder, as there was never an implicit guarantee to protect capital.
2. Offer the junior debt holders a warrant against the much riskier debt. It could well be argued the riskier debt never carried an implicit guarantee (such as junior debt).
(This is where it really gets interesting. The senior debt holders…)
3. Break up the senior debt into two components. 85% -90% would remain as is (senior debt) while the 10%-15% would be taken as equity. The equity component would carry a US government buy-back (put) for 3 years at the face value. This means that any holder could go and redeem the equity component from the US government at 100 cents in the dollar.
This achieves several things. It allows Freddie and Fannie to stay in business with well-capitalized balance sheets. New equity would reduce leverage to about 10:1 and essentially recapitalize the two institutions allowing them to stay in business writing new loan insurance in a more conservative environment. More importantly it would allow the government to remove the implicit guarantee for all time.
Once the market understood the US government is there for three years guaranteeing the equity portion the price of the equity coupon would probably rise above the face value and allow the US government to avoid having to fork over any money at all.
The overall effect is that it could stabilize the US housing market.
It’s a very elegant scheme.
One other thing:
A few Australian journalists were suggesting we introduce a similar deal in our market when our rates tightened. The potential default in the US of 50% of US GDP should shut them up for ever.