What's Driving Fannie and Freddie

Fannie and Freddie are down again; the shares are so cheap at this point that even a relatively modest fluctuation of less than 80 cents in the Freddie share price will hit the headlines as a 20% move. The fact is that they're not plummeting this morning, as the headlines would have it: they've plummeted already, and now they're fluctuating at levels modestly around zero since no one really has much of an idea what the option value of the shares might be.

Why are the shares at zero (plus a little something for option value)? Because Hank Paulson is a ball-buster, as he proved with Bear Stearns, and if he's going to have to inject capital, the markets are convinced that he's going to require the existing shareholders to be wiped out. He doesn't have to do that, of course, but he will: after all, if government capital is the only thing keeping the GSEs functioning, then it's hardly fair that the primary beneficiaries of that capital infusion should be the shareholders rather than the taxpayer.

The more interesting question is why the GSEs are still paying such a high premium to fund themselves. Freddie paid 113bp over Treasuries to issue five-year notes yesterday, even though Paulson has made it crystal clear that he stands behind that debt.

Here's my theory: any company's bond spreads naturally gap out whenever its stock approahes zero. In this case, there's a countervailing force -- the moral hazard play, whereby you don't trust Freddie the standalone entity to pay you back, but you're pretty sure that someone (the US taxpayer) will cough up if push comes to shove.

The problem is that although certain hedge funds might be perfectly happy making that moral hazard play, most of the people who historically buy GSE debt like to think that they're buying something which is more or less risk-free in its own right. Yes, they've historically been reassured that there's a government backstop, but there's a difference between being reassured by the backstop and relying on it.

So let's say that a large number of historical buyers of GSE debt (like, say, the Chinese government) decided that if they wanted to take US government risk, they'd much rather just buy US government debt, rather than relying on not-entirely-explicit pronouncements from the Treasury secretary. Right now, there's not a huge amount of liquidity in global debt markets, and the absence of those buyers can drive rates up quite a lot. It might look irrational -- it might be irrational -- but it's not hard to see how a company in trouble will have difficulty raising billions of dollars these days, no matter how much government support it has.