"Safe" Investments

Thursday, August 21, 2008


Fannie Mae and Freddie Mac's stocks have long been considered some of the safest equity investments in America. This assessment was predicated on their quasi-government status and the assumption that the U.S. government was the implicit guarantor of the two company's liquidity positions. Yet, this guarantee has proved to make these companies more risky, not less.

Operating with this implicit guarantee the companies were able to raise debt with a minimal spread over Treasuries. The low cost of capital allowed Fannie and Freddie to leverage themselves to much greater levels than other much smaller mortgage lenders. Their risk exposure was clouded by the guarantee.

Equity investors failed to recognize the true effects of this government guarantee. While it has yielded out-sized profits it has made equity investments terribly risky. A credit crunch would have an amplified effect on the companies' assets. When the scenario is actually played out, common stock holders will be left with worthless paper. The belief that these stocks were safer than others was completely incorrect. The guarantee has given investors a false sense of security. Investors did not realize that the "safety" of an assumed bailout that, if ever exercised, would erase equity values, is clearly not safe at all.

Scenario analysis is crucial when deciding on a potential investment. In this case, the stocks were considered safe because, in the event of a crisis, taxpayers would bail the company out. But, if the governemnt actually ever bails out the company, equity investors will lose their stakes. Obviously, this was a major flaw in logic and a lesson to be learned.


Post a Comment