A quick search on Fannie Mae and Freddie Mac on Google News yields more than 40,000 stories on the Internet from the past week. Suffice it to say, they've been in the news. With their stock prices plummeting, home foreclosures accelerating and Bernanke/Paulson/Bush doing a seemingly endless string of glorified public service announcements trying to soothe the fears of homeowners, clearly something significant is taking place. So what's happening behind the doors at those cutesy-named corporations? And how does this impact global markets? As we see it, the salient points are as follows:

• Federal National Mortgage Association ("Fannie Mae") was founded as a government agency in 1938 as part of the New Deal to provide liquidity to the mortgage market. For the next 30 years, Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States. In 1968, to remove the activity of Fannie Mae from the annual balance sheet of the federal budget, it was converted into a private corporation. At about the same time, Congress chartered Federal Home Loan Mortgage Corporation ("Freddie Mac") as a private corporation to provide competition in the secondary mortgage market, and to end Fannie Mae's monopoly.
• As government-sponsored-enterprises (GSEs), Fannie and Freddie enjoyed a couple of benefits that ordinary financial institutions did not. First and foremost the two can issue debt at much narrower spreads to Federal Treasury bonds than other financial institutions as there exists an "implicit guarantee" in the market that in the event of a credit default the government will intervene and protect debt-holders. In fact there are many examples (the law that authorizes GSEs, the securities issued by GSEs, public communications from the corporations themselves) stating that the securities issued by Fannie and Freddie carry no government guarantee of being repaid. Secondly, the regulation of the GSEs is lighter than it would be if they were ordinary banks inasmuch as they can make use of suspect capital sources (unrealized losses on derivatives, unrealized losses on securities classified as 'available for sale', deferred tax assets) to bolster their capital positions and fulfill the capital-adequacy requirements of their regulator OFHEO.
• This combination of access to cheap financing (the Congressional Budget Office estimated in 2003 that the value of the annual "subsidy" to the GSEs was $23 Billion...really) and modest regulatory oversight set the table for Fannie and Freddie to come to own or guarantee more than half of the $12 Trillion US mortgage market. Along the way, the two became extremely profitable, shareholders realized enormous gains (Fannie Mae's stock returned a staggering 28.8% annually between 1981 and 2001) and, you guessed it, management managed to considerably enrich themselves (Fannie's CEO Daniel Mudd brought home a tidy $11.6 Million last year, despite his stock price being cut in half).
• However, not unlike a tight-rope walker or an "Eval" Knieval stunt, this combination of growth, greed and innovation was a dazzling performance... until it stopped working. When the mortgage market turned, Fannie and Freddie found themselves in the unenviable position of possessing balance sheets with declining assets (their portfolio of mortgage-backed securities) and rising liabilities (guarantees on mortgages they've sold that are increasingly going into default). Oh and did we mention, the two GSEs are HIGHLY leveraged businesses. By some estimates, if you were to back out the dodgy capital sources mentioned above, financial leverage at Fannie and Freddie is in the ballpark of 100-1.
• Now that this precarious business model has been exposed (seriously, where were the Risk Management personnel who were supposed to model what would happen if the US real estate market ever turned down?) the market is bracing for significant write-downs from Fannie and Freddie. As it stands, at the end of the first quarter of this year, Freddie itself revealed that the fair value of the company's net assets (i.e. assets minus liabilities) was -$5.2 Billion, i.e. the company could be heading towards insolvency. The situation at Fannie is not much better. The inevitable conclusion to this soap opera is that these two need to raise capital (NOW!!)... trouble is, their stock prices have been obliterated, (off close to 90% each since last August, when the pair had a market value of roughly $135 Billion... which equals the current combined market caps of Goldman Sachs, Morgan Stanley and Merrill Lynch) making raising equity capital highly dilutive to existing shareholders.

So what happens now? Do they just go bankrupt and cease to exist? No, their role in the secondary mortgage market is simply too significant for them be to be allowed to fail... the result would be tighter lending, higher mortgage rates, greater foreclosures and a political nightmare. Well how about a Bear Stearns-esque rescue by one of the mighty brokers or hedge funds? Not likely, given the abysmal operating conditions described above, it doesn't make much sense for new investors to wade in (besides, successful hedge funds don't become so by mistaking Ladas for Ferraris). This leaves (once again, you guessed it) the taxpayers. Like over-zealous children who left home years ago to strike out on their own, it looks like Fannie and Freddie are coming home to the loving embrace of the federal government (or perhaps more correctly, their Uncle Sammy... couldn't resist). This means that the government will likely explicitly guarantee the debt of the two companies, although some sort of restructuring seems inevitable (i.e. debt holders will have to accept new terms and may get less than 100 cents on the dollar)... oh and the equity holders will get nothing... no surprise there... debt restructuring and shareholder bail-outs are about as compatible as Sid and Nancy.

For the markets in general this is a mixed bag... in terms of grief stages it looks like we've moved from the Denial Stage to the Bargaining Stage. In the short/medium term uncertainty will be relieved from the market, the mortgage market won't be destroyed and the financial system as we know it will continue to tick along. In the longer term, US Federal indebtedness increases, budgets are cut, taxes increased and the citizenry bears the brunt... and the negative knock-on effects on the economy are as you would expect. In short, this will be a long-term hit to the economy in exchange for a short-term boost in confidence. Expect that we'll skip over the Guilt Stage (Wall Street has little time for feeling guilty, it cuts into the Cristal drinking time) and move next to the Anger Stage (angry shareholders, indicted managers) before eventually settling into Depression and Acceptance Stages. Of course, the government could decide it doesn't want to shoulder this burden and inject just enough capital to keep Fannie and Freddie alive, leaving them to fend for themselves as (mostly) public companies with a new set of more stringent regulations. Of course, look where regulatory oversight has gotten them to date.

She'll go 300 hectares on a single tank of kerosene

In other news...

Can it get any worse for MBA students? Facing a bleak job market on Wall Street, the finding two years ago that more than half of MBA students admit to cheating on exams/course work, and the 34 students at Fuqua (Duke) caught cheating last month, now it seems that even the GMAT exam is under fire. The online test prep company Scoretop is accused of leaking "live" questions (i.e. questions that are on the actual GMAT exam (which is used as a benchmark for Business School admission)) to test-takers who were willing to pay $30 for access to the VIP section of the site (in what universe does having $30 make you a VIP?). It seems the rush to introduce ethics courses into the MBA curriculum in the wake of the Enron/WorldCom debacles in 2001/02 has had only a modest impact.