Poole Can't Keep His Mouth Shut

Recently retired ex-St. Louis Federal Reserve President William Poole said yesterday that Freddie Mac and Fannie Mae, the two U.S. mortgage government sponsored entities (GSE's)were "insolvent" and raised the prospect of a government bailout. Mr. Poole has a history of getting it wrong and opening his mouth at the worst possible times, and this statement was the height of irresponsibility.

The stock prices of both Freddie and Fannie had already been severely punished. Mr. Poole's irresponsible comments pushed the shares even further. Worse, it took away any chance of the two firms being able to raise private capital by issuing new common stock. The stock price is simply too low at this point to make this a viable alternative.

Fannie and Freddie, their regulator, and Treasury Secretary Paulson have all said over the last two days that the GSE's are adequately capitalized. But in this cynical market, where Bear Stearns CEO claims adequate capital 2 days before collapsing, these statements are viewed with suspicion. Who knows what the truth is.

This is not a question of whether Fannie and Freddie will cease to exist. In the end, the government can nationalize them, and longer term they will be fine. They are in a profitable business that in normal times generates strong cash flow. But the vintage 2005 to 2007 loans have a much higher level of toxicity than normal times and could quickly consume the GSE's capital.

The best alternative is for private capital to find its way to the GSE's. The next best solution would be for the government to provide capital in exchange for warrants. This is what happened during the bailout of Chrysler. The Chrysler turned out to be a very profitable transaction for the government. The least desirable solution is for the GSE's to be nationalized.

Maybe we can ring up the Saudis and say, "You know all those gizillions of dollars we've paid you for oil, and will continue to pay you? Could you take just $75B of the gizillions and recapitalize Freddie and Fannie for us?"

Again, Freddie and Fannie, or some recapitalized government agency, will continue to perform the function of providing liquidity to the mortgage industry. There was a brief rally this afternoon in the market when Reuters reported that Federal Reserve Chairman Bernake had told the GSE's that they could access the discount window. But this information has yet to be confirmed by the FMOC.

There is almost no scenario at this point that will save the holders of the common stock. Like a bankruptcy, the bondholders of the secured debt end up owning the assets - the shareholders of common stock get zero.