Serious negatives in Fannie Mae/Freddie Mac bail-out

The US Treasury was warned on the eve of its bail-out of big mortgage houses, Fannie Mae and Freddie Mac, of serious negative implications for other large financial institutions if it, at the same time, bailed out Subordinate Security holders.

The bail-out, ultimately announced in the US on Sunday, is expected to have a significant impact on a number of major financial institutions this week.

In a letter to the Treasury sent over the weekend, financial services house Pershing Square Capital Management said it understood that a Treasury plan regarding Fannie Mae and Freddie Mac might be announced over the weekend and suggested that in order to minimise risk to taxpayers while being equitable to other institutions, the Treasury considered purchasing senior subordinate debt in the two companies.

It said that it did not believe the Treasury could purchase sub-debt, preferred stock or common stock without incurring an immediate loss to taxpayers because of the enormous amount of existing debt senior to those instruments.

Under the plan, announced by US Treasury secretary Henry Paulson, the US Government will take over the management of the two companies and get rid of its boards and chief executives.

It will take ownership of preferred stock, ranking above that owned by common shareholders.

Paulson said Treasury believed that most institutions holding the stock could weather the write-downs, but he also advised any smaller institutions to contact their regulators immediately if they were facing difficulties.

The government is also setting up a secured credit facility for Freddie Mac and Fannie Mae to serve as a backstop if they have difficulty borrowing funds in the capital markets.

“This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July,” Paulson said.

The government is also undertaking a third measure: a program to buy mortgage-backed securities. It hopes the program will narrow the spread between mortgage and official interest rates and help bring down the rates being charged to householders.