The current market environment is producing difficult decisions for those with both long and short positions. As reported in a recent Reuters article, hedge fund manager and short seller Douglas Kass has been cutting back on his positions. As mentioned by Kass: "It is a dangerous time for the longs and for the shorts. This is a time to watch and not a time to play. It is time to move to cash." Kass has recently said he was still short Fannie and Freddie, even after the government takeover. Watching and not playing may end up being good advice as it certainly is a difficult and dangerous time for both the longs and shorts. As with any panic and sell-off, there is always a desire to lighten up, yet always the worry of selling at the bottom. I must say that it kind of amazes to me that we have not sold off more given some of the news hitting the street, especially when you consider large sell-offs from the recent and not so recent past, such as the 22% sell-off in the DJIA in 1987. No doubt this was a different situation, circumstance, computer network trading system, and general market psychology, but it was also a situation that did not see they types of buyouts and failures (and potential failures) that we have seen with Lehman Brothers, Merrill Lynch, AIG, and Fannie and Freddie, not to mention the on-going housing and credit crisis and previous Bear Stearns failure. Not sure if that means we have responded better this time, or whether the real pain is yet to be felt. The VIX is signaling panic again as it moves significantly above 30, but it did so back in March as well. Time will tell.

As reported at the WSJ, the assets and liabilities of Fannie and Freddie will not be placed onto the federal books for now, even after the recent takeover by the government. This decision seems odd given that one of the main reason for the takeover was to instill confidence that the government was there as a backstop. Even CBO director Orszag thought that both companies should be incorporated into the federal budget. Given that it is an election year, it is not surprising that Washington would not want increase the size of government, or at least the appearance of doing so. The reason given for keeping Fannie and Freddie off the budget is apparently the need to take "... into account the degree of federal control of the companies, the economic risk to the taxpayer, and the temporary nature of the government's arrangement with the companies." Yet, the federal budget has always considered revenue and outlays of various programs and activities that the government has some control over, even if they do not run them directly.

So in the mean time, both Fannie and Freddie will have their combined $1.5 trillion of debt placed in a separate category and not added to U.S. publicly held debt - kind of like a Special Purpose Vehicle for taxpayers. Now if we can only get the companies moved to the Cayman Islands, maybe we could also reduce our tax burden. Then again, pledging up to $200 billion of capital for $1 billion in equity may generate a tax loss savings in the future, so maybe we should keep our options open. Of course, with both hands in the cookie jar, this may end up being nothing more than just another case of robbing Peter to pay Paul. I just haven't figured out which one I am yet (but I have a good guess).

Nothing too earth shattering here, and the Buffett interview is rushed as he on the baseball field at Boston to throw out the first pitch, but it nonetheless highlights how we all are in the same situation. When asked about the uncertainty of the markets, whether housing will recover, or whether Fannie and Freddie will be expensive to taxpayers, he basically says, "I don't know." Probably the most honest statement yet, and an illustration of how were are all just feeling around in the dark with regarding to the housing and credit crisis. There will be winners and losers in the end, as there already have been with Fannie and Freddie, but hope is still entering into the equation. Just ask Lehman.

Source: Wall Street Journal Online Video

Driven by a declining housing market, and aided by the Treasury Secretary's recent decision, hedge funds that bet against Fannie and Freddie racked up big gains on Monday (see Reuters article). Hedge fund Seabreeze Partners, run by short-seller Doug Kass, was short both companies. Kass's big bet has helped his fund to be up over 25% this year. William Ackman's Pershing Square Capital Management has also made money betting against Fannie and Freddie. Short-sellers have often been vilified, but now they have reason to gloat, causing one hedge fund manager to state: "I don't know how they could get it so wrong. There were so many red flags. I feel sorry for them." One trader that was not as fortunate was Legg Mason manager, Bill Miller, who had increased his holding in Freddie to 79.8 million shares, causing his fund to be off 31 percent for the year. Miller had previously beaten the S&P 500 for 15 years. Some speculate that the Freddie Mac losses may put pressure on Miller to step aside. The old saying, "So what have you done for me lately" never seemed so brutal.

As of now, the Fannie and Freddie story is pretty well known, and has been looked at from a number of different angles (see various articles and posts here, here, here, and here). Now we find out that the auto industry is set to press Congress for $50 billion in low-interest auto loans (see CNN Money article). The government loans are expected to be used to help modernize plants and help the car companies make more fuel efficient vehicles. Congress had already authorized $25 billion in loans last year, but apparently that is now not enough. It is believed that the loans would have rates between 4-5 percent. Even though market rates are fairly low already, the credit ratings of both Ford and GM have fallen below investment grade, making it difficult to borrow anywhere near 5 percent.

This of course makes one wonder at which point all of this stops. Sure, it is important to keep Fannie and Freddie and the general housing mess from bringing down the financial markets, but at what cost? Starbucks has fallen on hard times. Should they get some type of bailout or support? What about Sears Holdings, with the struggling Sears and K-Mart retailers? Is it time for the airlines to go back to the well? The argument of course is usually attached to the financial sector, talking about things like contagion, or national interest, for industries such as defense and manufacturing. But where is the consistency? Just as loans are being requested to help build hybrids, electric cars, and other alternatives, other measures to increase low cost electricity or reduce our energy independence are met with resistance. Even more unsettling is that by choosing to bailout Fannie and Freddie, we (the taxpayers) are now all investors in the mortgage markets, whether we choose so or not. To add insult to injury, we can even lose more than our initial investment.

Of course the real issue of concern may not be whether or not a specific industry or company is receiving low interest loans or a nice government contract, or whether we are being forced to invest in risky companies against our will, but whether the trend of privatizing profits and socializing risk is really good for free markets. As readers know, I often discuss the need for risk management, but unfortunately for many companies their idea of risk management is simply letting the government take the reins when things go bad. Again, the point is not specifically about the current problems or plan proposed by Secretary Paulson. It appears that he had no other choice, and as he stated on CNBC: "played the hand he was dealt." Yet, should it have gotten to this point?

As is now obvious, banks kept making loans without worry of whether homeowners would pay them back. They could simply sell the loans off to Fannie and Freddie, sponsored in part by the government. While Fannie and Freddie were indeed "just" sponsored entities, there was always a "wink-wink" understanding that the government would step up in times of need. As such, both risk and return were adjusted accordingly. Yet, this was part of the problem. By having in place what amounted to a zero deductible insurance policy, Fannie and Freddie could go off and look for ways to juice returns by creating portfolios that really had no purpose other than to help meet quarterly numbers and make Wall Street and shareholders happy - all the while knowing that if things got bad, Uncle Sam was there to save the day. Well, that day has come, and now the government is left with few options, tax payers are left with more risks and unwanted investments, and the free-markets are a little less free. Where does it stop?

The Washington Post reports today how the Congressional Budget Office Director, Peter Orszag, feels that Fannie and Freddie will likely cost taxpayers less than $25 billion, but further deterioration in the housing market could force an infusion beyond $100 billion. The quote of the day comes directly from Orszag: "There is significant uncertainty involved here," Orszag said. The cost "could be zero. It could be $100 billion." At least he is honest. Like the market, no one really knows. Of possible contention in the recently drafted legislation is how the protections for taxpayers were not specifically spelled out but were left to the Treasury to define.

Source: ClipSynidcate / Bloomberg
At the end of Q1, both Fannie and Freddie had liabilities of $1.6 trillion, plus mortgage guarantees and investments totaling $5.2 trillion. Unfortunately, the excess of their assets over liabilities may have fallen to $7 billion. Still, the $25 billion estimate may also end up overstating the cost since it does not reflect the value to the government of any purchased stock received for their $25 billion investment (assuming the company needs to be taken over). As quoted in the article:

"If we do this right, taxpayers will not spend any money because the markets will be confident in the vitality of Freddie Mac and Fannie Mae, and the markets will correct themselves," said Sen. Judd Gregg (R-N.H.). "But if the markets don't correct and Fannie Mae and Freddie Mac become unstable, then we've got very serious problems well beyond anything in this estimate."

Of course, if the government does step in, then the confidence has been lost, and the value of the stock at that point is most likely less than their bailout investment. As argued, it still appears the issue comes down to a matter of confidence (to some extent), which partially explains the need for Treasury to have an open checkbook, or at least give that impression. Open checkbooks are nonetheless scary, and often end up being used to buy more than you originally went to the store for, but in this instance, they may have no choice. Too little, and confidence is lost. Too much, and either the market gets scared, and/or moral hazard starts to creep in. I wonder if Treasury Secretary Paulson is missing his Manhattan corner office right now?