Fannie Mae (FNM) and Freddie Mac (FRE), the pillars of the US mortgage market, are falling off a cliff. But any proposed government bailout would have dire consequences for the dollar, says Dan Denning in The Daily Reckoning Australia. This from Bloomberg:

“Fannie Mae and Freddie Mac tumbled to the lowest in 17 years in New York trading after former St. Louis Federal Reserve President William Poole said the companies may need a government bailout and UBS AG analysts cut their price target for Freddie Mac stock. Virginia-based Freddie Mac was insolvent based on fair value accounting measures last quarter and Washington-based Fannie Mae may become insolvent next quarter, Poole said.

Fannie Mae and Freddie Mac, which own or guarantee almost half the $12 trillion of U.S. home loans, have raised a combined $20 billion in capital since December. While most of the fresh cash has come from preferred stock, Rosner said the companies may be forced to sell common stock, diluting existing holders.

“I don’t think the companies seem to understand that they have no choice but to raise equity no matter how dilutive it is,” Rosner said. “And the federal government will not back them unless they do so.”

Dan Denning says both companies are sitting on a black hole. He is concerned that neither own enough capital to cover the potential losses they face. This risk is showing up in higher bond yields and credit default swaps (insurance against debt default):

Fannie and Freddie have trillions of dollars in assets. But remember, a bank’s assets are someone else’s liability-a loan is a promise to pay. The trouble for Fannie and Freddie is that combined, they own or have guaranteed over US$5.3 trillion in debt and securitised mortgages. Their capital, on the other hand, is slender by comparison, with Fannie having US$38.8 billion in capital and Freddie US$16.3 billion.

Many of Fannie and Freddie’s assets are held in off-balance sheet vehicles. That means the banks don’t have to boost capital to protect against asset losses since the assets aren’t official. They are more like illegitimate children that are maintained in a second home, technically existing but not officially acknowledged. Yesterday’s big hubbub was based on what would happen if the Government Sponsored Enterprises GSEs had to move those assets on to the balance sheet (move the kids from the mistress into the household with the wife and kids from the Christmas cards).

The longer-term and not at all trivial or amusing question is how fundamentally sound are the assets owned and guaranteed by the  (GSEs)? The GSEs have a lot of subprime debt that was issued late in the game to the riskiest borrowers. They say they can hold to maturity and don’t have any need to sell it.

But what about the soundness of the rest of their portfolios? According to the credit market action yesterday, the answer is that those portfolios appear “increasingly less sound, or at least much riskier.” Fannie sold US$3 billion worth of bonds this week to finance its mortgage operations.

Those two-year maturity bonds were priced at a 3.27% yield-which is nearly three quarters of a percentage (74 basis points) higher than what U.S. Treasury notes of the same duration pay. Both yields, by the way, are probably still less than the rate of actual U.S. inflation, hence negative real interest.

“You wanna borrow money Fannie? You’re gonna pay.” That’s what the market’s telling us. That spread between Fannie notes and U.S. Treasuries is the biggest since 2000. And the cost of insuring Fannie and Freddie debt against default has gone up too.

We will not ruin your day by discussing credit default swaps in detail. But think of it this way, when you get in a car accident, your insurance premiums go up. Rising credit default swap rates are the market’s way of telling us it thinks Fannie and Freddie are more likely to get in an accident, so the cost of insuring their bonds against default has gone up.

Mr. Market is understandably nervous about whether Freddie and Fannie can hold on. If they can’t, all hell will break loose.

Citing a recent report from Standard & Poor’s, CNN Money says the “doomsday scenario” of a government bailout would cost taxpayers $1 trillion. It could also force the agency to downgrade US creditworthiness.

Dan says a government rescue would be a gargantuan task that would destablize the US economy. It could also sound the death knell for the US dollar:

If the U.S. Government chooses to bail out the Government Sponsored Enterprises, what do you think it will do for the value of the U.S. dollar? Taking on the GSEs massive liabilities and dubious assets is a gargantuan financial task even for the U.S. Government, used to gargantuan financial mismanagement. It is a whole bottle of poison pills, swallowed in one big gulp.

We believe investors seeking safety in the U.S. Treasury market are misunderstanding the fundamental risk of a crisis in the GSEs. That real casualty of a GSE meltdown is the global dollar standard itself, which is already under a lot of strain.

A Government Sponsored Enterprise nationalisation would cause the dollar to buckle under the weight of additional dollar denominated obligations for a government that already has many more than it can realistically pay. Bond yields on American government debt would rise and prices would plummet. The U.S. economy would be plunged into a truly terrible reckoning for its credit excesses.

So are we witnessing the opening lines of the final act of the dollar crisis? And if so, what does it mean for resource prices?

Source: The Two Pillars of the US Mortgage Market, Fannie Mae and Freddie Mac, Wobbled Again Yesterday