In a surprise move over the weekend on 7 September, US Treasury Secretary Henry Paulson announced to the world that the US government will be taking over the operations of Freddie Mac and Fannie Mae as well as assuming their respective debts. Both companies have a 50% market share of the mortgage loans in the US amounting to almost US$6 trillion.

Freddie and Fannie were born in the 1930s as part of a government initiative to rescue the economy and the housing market at the aftermath of the Great Depression. Americans back then faced a severe financial crisis and were unable to afford homes and, thus, the quasi-government bodies of Freddie Mac and Fannie Mae set up these two companies – although both are publicly-listed – to solve the housing problem.

After lending money to homebuyers, Freddie and Fannie then package these loans into debt and resell to investors in exchange for interest payment. Both companies make a profit through the difference in the rate they charge borrowers and they interest they pay to investors. For example, Freddie and Fannie will charge homebuyers an interest of 8% per annum and then pay an interest of 7% to investors of its bonds. Both companies will make a profit of 1% from the difference and, in the process, assume no risk.

As both companies are related to the government, its bonds are given a AAA rating by credit agencies and are very popular among investors who include governments of various countries. The Chinese government alone holds hundreds of billions in bonds of Freddie and Fannie, which have a total debt obligation of nearly US$5 trillion.

As a result of the big fall in home prices, American homebuyers are finding it hard to service their home loans and this has affected the cash flow of Freddie and Fannie. Without adequate cash, both companies face the problem of paying the interest on their bonds as well as bond redemption.

Can Freddie Mac and Fannie Mae be allowed to fail? Once both companies are left to fail, it will result in US$5 trillion being wiped out from the financial markets and it will lead to a financial catastrophe.

The US government had no choice but to “nationalize” Freddie Mac and Fannie Mae, which means that the bonds of these two companies are now as solid as US Treasuries since they have the backing of the US government.

Once the news was released to the world, global markets rallied on 8 September only to succumb to profit taking the very next day. The hefty gains, perhaps, led to short-sellers taking action by pushing the markets down.

The “nationalization” of both companies is indeed a piece of good news, but there are fundamental problems facing the US economy. One piece of good news is simply not enough to even out several pieces of bad news such as the breakdown in talks between Lehman Brothers and the Korea Development Bank, which had earlier signaled its intention to take a stake in the former. The share price of Lehman Brothers plunged 40% in a single day and dragged down financial stocks such as AIG, which fell by nearly 20%.
The safest bet now is to stay at the sidelines and avoid the market totally. Consider buying only when the Straits Times Index falls by more than 100 points in a single day.