A Rescue Plan for Freddie Mac and Fannie Mae

The Dow industrials broke through the 11,000 level, a level investors have not seen since summer 2006, ending just a bit above that threshold.

Tensions over the perilous health of the U.S. mortgage finance giants Fannie Mae and Freddie Mac added to a chaotic close. Despite an earlier wire report to the contrary, the Federal Reserve announced after the close that it does not plan to extend the discount lending facility to these troubled institutions.

So what to do about these twin pillars of housing finance, so key now to Congress's housing bailout?

Here's what you do, if needed. Give them a 10-year loan similar to the one given to JPMorgan Chase (JPM) when JP parked its ambulance in front of Bear Stearns on St. Patrick's Day, did a cat scan on Bear's assets and said wait a second, $30 bn of Bear's stuff is truly rotten, give us a 10-year Fed loan (at a cheap rate of just over 2%), backed by these assets, or no deal.

You sell a Fannie-Freddie loan to the taxpayer and the stock market by saying, the US government will make money on this loan, we'll get that money back and then some by charging an interest rate, pegged, say, two percentage points above the 10-year treasury, and then we get to sell some assets off too. Make the taxpayer and the market believe the government will profit off any rescue. That's the key.

Just like Federal Reserve chairman Ben Bernanke did in explaining away in testimony before Congress its orchestrated, shotgun marriage between JPMorgan and Bear, where he reiterated that the Fed will make money on its loan to JPMorgan and the collateral sale too (now overseen by Black Rock). The size of the loan is another matter-some say $50 bn, others say $100 bn.

The taxpayer and the markets must be reassured that the government simply doesn't let things fall to pieces, that the government will profit from any rescue.

These two simply cannot go under, nor can the US take them on its balance sheets. Fannie and Freddie buy mortgages from banks so banks can then turn around and have more money to make loans to borrowers. They also sell mortgages to investors as securities, and they get paid a fee to guarantee these securities if they go bad.

Fannie Mae and Freddie Mac, own or guarantee about half of the $12 trillion of US mortgages. They provide funding for nearly three-quarters of new US mortgages.

And together they now oversee 83% of mortgage backed securities, up from 33% just a couple of years back.

Together they have $81 bn in core capital and $54 bn in shareholder equity supporting that $5.3 tn, which equates to the entire US public debt held in private hands (not including the off balance sheet items).

Get this, another $3.3 tn worth of their debt and assets sits in off balance sheet vehicles. The hot zone in their books are the $260bn in sub prime and what are called Alt-A loans, which sit between the rotten subprime stuff and the prime loans. 

Neither of these mortgage giants is backed by the government, however. They each have a $2.25 bn pipeline into the Treasury in the form of a credit line.

I don't think we are headed for a calamitous nationalization of these two giants. The credit rating for the entire country would drop to junk status, the dollar would fly off a cliff, and oil would go higher than $200, as oil is priced in dollars.

The government will not allow this national nervous breakdown.

Besides the idea I gave at the top, there is a way to avoid a financial nuclear winter in the midst of this heated market and a hot summer.

And sit tight, too, as the financials, whose rotten profit results have been stinking up place, will see Merrill Lynch (MER) and Citigroup (C), already struggling with bombed out share prices, out with their latest quarterly earnings next week.

A rights offering to Fannie and Freddie shareholders has been discussed, where stock is sold at a discount to investors, with any leftover rights not exercised bought by US government. That's a good idea. Other ideas involve the Treasury buying stock in the companies, or a purchase by the Fed of some of their debt or mortgage-backed securities. Stay tuned.