It's Time to Unload Freddie and Fannie

Stop trashing Ben Bernanke -- the looming failures of the two largest government-sponsored entities (GSEs), Fannie Mae(FNM Quote) and Freddie Mac(FRE Quote), are bigger than anything we have seen before. In fact, Bernanke himself has been talking for years about the "widespread misperception by investors that the U.S. government would not allow a GSE to fail."

Congress and some investors were just not listening. Now is the time to ask, what if the debt and mortgage-backed securities of these firms are no longer investment grade?

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Last year I wrote an article on TheStreet.com saying that Fed Chairman Bernanke was going around warning about a significant financial failure, one that could redefine the meaning of the words global financial crisis.

In March 2007, at the annual convention of the Independent Community Bankers of America in Honolulu, Bernanke clearly said that all financial crises 1.) involve the failure of a large entity and 2.) originate from failures of due diligence or discipline by market participants. He clearly spelled out a case against the preferential financing incentives for Fannie and Freddie that allowed them to acquire and increase the size of their portfolios. He clearly pointed to what some call the elephant in the room: the GSE mortgage portfolios.

So what's Bernanke's problem with these two government-sponsored entities?

Bernanke's gripes are fairly basic. The combined outstanding debt and mortgage-backed securities (MBS) obligations of the two companies exceeded $5.2 trillion in 2007, more than the $4.9 trillion of public government debt at the time. The effect, again according to Bernanke, is that Freddie Mac and Fannie Mae are undercapitalized entities that, unlike banks, will not protect investors.

Not Just Stock

Don't assume that this just means the equity. These are Bernanke's words, "Only if GSE debt holders are persuaded that the failure of a GSE will subject them to losses will they have an incentive to exert market discipline." In other words, debt investors must also bear the burden of a restructuring when it occurs.