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We all knew this was coming:

The U.S. government will take control of Fannie Mae and Freddie Mac after the biggest surge in mortgage defaults in at least three decades threatened to bring down the companies making up almost half the U.S. home-loan market.

"We have determined that it is necessary to take action,"' Treasury Secretary Henry Paulson, who engineered the takeover along with Federal Housing Finance Agency Director James Lockhart, said in a statement today. "Our economy and our markets will not recover until the bulk of this housing correction is behind us. Fannie Mae and Freddie Mac are critical to turning the corner on housing."

Lockhart said his agency has placed Fannie Mae and Freddie Mac into conservatorship. This was because the companies "cannot continue to operate safely and soundly and fulfill their critical public mission without significant action to address our concerns," he said in a statement.

Why is this happening now? Well, it seems that the two quasi-public companies haven't been so forthcoming after all. Is that a surprise?

Last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac's capital position was worse than initially imagined, according to people briefed on those findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies' capital resources and financial stability. One person briefed on the company's finances said Freddie Mac had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of this year, which would not need to be disclosed until early 2009.

The details are staggering:

Accusations of questionable accounting are not new for either company. Earlier this decade, both companies paid large fines and ousted their top executives after accounting scandals.

Freddie Mac's current chief executive and chairman, Richard F. Syron, joined the company in 2003 after the former managers revealed that they had manipulated earnings by almost $5 billion. The next year, Fannie Mae's chief executive, Daniel H. Mudd, was promoted to the top spot after that company was accused of accounting errors totaling $6.3 billion.

The accounting issues that brought so much urgency to the bailout appear to center on Freddie Mac’s capital cushion, the assets that regulators require them to keep on hand to cover losses.

The methods used to bolster that cushion have caused serious concerns among the companies' regulator, outside auditors and some investors. For example, while Freddie Mac's portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices.

Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value. But other financial institutions have written down similar securities, to comply with "mark-to-market" accounting rules. Freddie Mac holds roughly twice as many of those securities as Fannie Mae.

And this accounting scam is particularly disgusting (why, exactly, is this legal?):

Freddie Mac and Fannie Mae have also inflated their financial positions by relying on deferred-tax assets -- credits accumulated over the years that can be used to offset future profits. Fannie maintains that its worth is increased by $36 billion through such credits, and Freddie argues that it has a $28 billion benefit.

But such credits have no value unless the companies generate profits. They have failed to do so over the last four quarters and seem increasingly unlikely to the next year. Moreover, even when the companies had soaring profits, such credits often could not be used. That is because the companies were already able to offset taxes with other credits for affordable housing.

Most financial institutions are not allowed to count such credits as assets. The credits cannot be sold and would disappear in a receivership. Removing those credits from assets would probably push both companies’ capital below the regulatory requirements.

What exactly does this mean for those involved, from shareholders to bond holders to the U.S. taxpayer? It's not entirely clear, although you can bet that regular shareholders will be wiped out but foreign governments will get their money back - all courtesy of you and me:

Investors who own the companies’ common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

The cost of the government's intervention could rise into tens of billions of dollars and will probably be among the most expensive rescues ever financed by taxpayers.

But the repercussions across the economy aren't entirely known. Gretchen Morgenson, from the NY Times, has been following this issue diligently over the past year, and she points out one particular area which is likely to suffer:

The potential effects of a rescue become more complex for the holders of Fannie's and Freddie's $19 billion in subordinated debt, so-called because it ranks below other bonds in the companies' capital structures.

As UBS analysts point out, because Fannie's and Freddie's subordinated debt is used when they calculate capital -- the financial cushion regulators require to support the companies' operations -- interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.

While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a "credit event."

Starting today, it looks like this "credit event" will now play itself out:

"If we reasonably assume that the Treasury would only intervene in the event that Fannie or Freddie is declared significantly under capitalized by its regulator," UBS analysts wrote, "then interest payments on the qualifying subordinated debt is automatically deferred for up to five years."

Because nonpayment of interest would be seen as a credit event, UBS added, entities that have bought protection on Fannie’s and Freddie's subordinated debt would be entitled to payment by the entities that wrote the insurance. This, even though taxpayers are standing behind Fannie's and Freddie's debt, not allowing it to fail. Talk about the laws of unintended consequences.

The problem now is that we don't know how far the ripple effect of losses will extend. And the reason we don't know that is because there are literally trillions of dollars of insurance issued to holders in case a credit event like this happens (they are called credit default swaps). But we don't know who owns what kind of securities, since most of the transactions are not publicly traded. That is, most of these gargantuan bets were made between investment houses and hedge funds that weren't required to reveal them to the public, since we live in a society that doesn't value regulation by the government. It seems like we're still paying the price for the Reagan Revolution from the '80's:

It is not clear how much insurance has been written on the subordinated debt. The actual holders of the debt very likely hedged their stakes with credit insurance, which is intended to protect buyers in the event of a default.

But speculators may have bought credit default swaps on the companies' subordinated debt even if they did not own any of the debt. A gutsier gamble than selling short Fannie or Freddie shares, buying credit insurance on the companies’ debt was essentially a bet against the implicit government guarantee that many felt was backing all the companies' obligations.

Because of the implied guarantee -- and the belief that it meant they would never have to pay out on the swaps -- sellers of credit insurance may have been overly eager to write contracts on Fannie's and Freddie's debt.

So the burning questions are these: Who wrote the insurance and do they have the money to pay those who bought it? If they don’t, what happens?

If the market for credit insurance were more transparent, we might know the answers. But these deals are private and largely hidden from view.

Finally, we have the scenario that the Federal Government will step in to make the parties unwind their positions, with one side getting off scott free and the other side taking massive losses:

It is possible, of course, that a Mac 'n' Mae bailout will be structured so as not to force credit default swap payouts. Or regulators could step in and require parties on both sides of the Fannie and Freddie credit insurance trade to unwind their stakes at heavily discounted levels. Such has been the nature of recent deals struck by financial guarantors like Ambac at the behest of the New York State Insurance Department. In one deal, the credit default swap buyer got just 13 cents on the dollar; in another deal, the buyer got 61 cents.

If regulators make such a move related to Fannie and Freddie, sellers of the insurance could escape dire financial problems associated with paying on the claims. But buyers of credit protection are apt to get far less than they think they are owed on the insurance. And if they have written the values of their holdings way up to reflect the increased likelihood of a default event, they will soon have to write them down again.

Remember, this is just one aspect of this bailout, where there are literally trillions of dollars at stake. It's indeed staggering.

Oh yeah, one other staggering part of this story: Richard Syron, Freddie Mac's CEO, has collected more than $38 million on compensation since he joined the company in 2003. $38 million.

Do you think he'll give any of it back?

Mortgage delinquencies continue to set new records, promising more losses and future write-offs for banks and other mortgage lenders, said economists at investment bank Dresdner Kleinwort. The problems are spreading from the subprime sector to prime loans, particularly to mortgages with adjustable rates and optional payment features. With unemployment rising faster, cyclical problems will now compound the damage caused by falling house prices.
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Madhumas

http://www.gov-auctions.org

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