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Frick and Frack

By       Message Bill Sharon     Permalink
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Frick and Frack were two Swiss comedic ice skaters of extraordinary talent who joined the Ice Follies and became international celebrities for nearly two decades in the first half of the 20th century.  One of their most famous routines was called "rubbery legs"- which entailed skating in a spread eagle position with their legs bending and flying out at different angles.  Always on the brink of disaster their audiences were torn between the anxiety of seeing them fall and the hilarity of their struggles to stay upright.  In more recent years, the appellation of Frick and Frack has achieved a more derisory meaning akin to a pair of individuals who are less than stellar in their performance; which brings us of course to Fannie Mae and Freddie Mac.

 

There is much conflicting data about the financial health of these two companies.  An analyst from Barclays Bank estimates that Freddie has a negative value of at least $20 billion and Fannie is at negative $3 billion.  Collectively they need to raise $30 billion before the end of September.  The likelihood of this happening from the usual sources is slim to none.  The Asian banks have slowed their investment in Freddie and Fannie debt to a minimum (they currently hold 35-40% of the outstanding debt) and while US investors are picking up the slack many of them are employing something called a "switch"-.  A "switch"- is where an investor agrees to buy a new debt issue only if the issuing bank will take back on older debt issue of equal value.  So it looks like the new debt issues is well received but in actuality Freddie and Fannie are not really raising the funds that it would seem that they are raising.

 

This sleight of hand is being employed is a fairly transparent attempt to maintain confidence; the emotional underpinning that sustains the markets.  It is the same device that the Federal Reserve has been using in extending loans of greater and greater amounts to banks.  The Fed, a consortium of private banks has in essence been lending money to its own members.  The problem with all of this is that the system and Freddie and Fannie in particular is more and more resembling the scrambling legs of Frick and Frack; although the ice is a lot thinner and the likelihood that they will fall on their faces a near certainty.

 

The next step in this drama increasingly appears to be nationalization of both of these troubled companies.  On the surface nationalization has the appeal of the taxpayers owning the assets of these failed companies (that would be the mortgages that have been securitized into mortgage backed securities).  Shareholders would loose what is left of their equity position and although that is still not a trivial amount and would no doubt result in a serious impact to the markets it is the normal result of the bankruptcy of a publically held company "" just ask the shareholders who held Enron stock.

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But there is an ugly problem that has the potential to have an even greater impact than the loss of shareholder value.  Fannie Mae and Freddie Mac have $19 billion outstanding in subordinated debt.  Subordinated debt is essentially the class of bonds that are at the bottom of the food chain.  Should a default or "credit event"- (the latter sounds so much nicer) occur it is likely that the interest on this debt could be deferred up to five years.  Again, that is an expected event but the problem is that deferring the interest on those bonds could trigger the payout of the insurance policies that investors bought to hedge against a default.  These policies are called credit default swaps and can be issued to investors who don't even hold any of the subordinated debt.  You can bet on a bond that you don't own defaulting by buying a CDS.  How much of this insurance is out there and can the companies who wrote the policies pay off?  Nobody knows.  As with the great majority of securities in the US and around the world these swaps are bought and sold in an unregulated auction market.

 

It is possible that a deal could be structured so that the credit default swaps would not be triggered by a bailout but you can be sure that there will be a lot of angry investors if that happens.  It might make betting on failure less attractive but in the near term we can expect a good deal of outrage about constraints on the free market.  The real question in all of this however is what is going to happen to the human beings "" people like you and me.

 

The best case scenario is that we influence our government to keep people in their homes.  This is a practical solution based on fundamental economics.  People who are still in their homes spend money in the businesses in their communities which keeps the economic engine running.  People in their homes would throttle down the continuing negative spiral in housing values.  People in their homes would form the firewall in the current economic meltdown.  No doubt that there would be cries of "socialism"- and dire warnings that we need to let the market work but we are well past that now.  A bailout of Fannie and Freddie will occur.

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The struggle is whether to recognize that confidence in the market can only be achieved if it is really warranted.  Recognizing that we have to return to establishing real underlying value will allow us to begin to takes the steps to transition to economics that reflect real creativity and solutions to human problems (free energy, robust agriculture, clean water, etc.).  Or we can continue to make the problem worse by trying the keep the current game going.  Either way there will be pain but the latter approach has little chance of getting Frick and Frack off the ice without a major catastrophe. 

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Bill Sharon has been conducting seminars, workshops and consulting assignments in the area of risk management for the past 15 years. His clients include: American Express ICEA JP Morgan Chase PricewaterhouseCoopers Interpublic McCann (more...)
 

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