Bailing Out Fannie and Freddie

Treasury has effectively written an unlimited capital put. Bondholders are reassured that the GSEs can issue any amount of equity capital required to protect their balance sheets.

Why would the GSEs ever need the actual capital? The puts ought to assure any debt rollover. So long as their operations stay cash flow positive, there isn't any reason to actually exercise the puts.

So the shareholders could easily live to fight another day -- they'll pay 10% on the first preferred tranche, but after that they keep any gains. Any losses end up at Treasury. They have to start shrinking their portfolios, but not until 2010, and until then they finance those portfolios at Treasury rates.

There is the possibility of dilution via those warrants. But that's _political_ risk, a gamble on government action. If the government won't blow up the equity now, why on earth would they ever do it?

Why is Treasury doing this? The trillions of GSE debt is held by all kinds of financial institutions, and used in all kinds of money market financing transactions. The increase in GSE spreads has marked down the value of all that paper -- slightly, but those losses are spread throughout the whole financial sector. And the instruments are much less reliable, which makes them much less useful for funding operations like repos, and less liquid stores for capital reserves. That's a real systemic threat.

Why doesn't Treasury wipe out the common shareholders? The GSEs have enough political cover from Congress to make that controversial, and enough legal cards remaining to make it uncertain. A fight over the common would only create uncertainty, which is the very thing Treasury is trying to avoid here.

The bottom line is that the GSE equity holders are getting very cheap equity, largely because they have become foundational to the capital markets and because their friends are prepared to hold those markets hostage to keep the GSEs afloat. The equity will have to be patient, and it has to bear political risk, but that's what the GSEs have always been about.