Thoughts on the Frannie Bailout

It's too early to tell how successful the Frannie bailout will be. Its ultimate success or failure will largely hinge on how many small and regional banks become insolvent as a result of having to write down their preferred shares in Frannie. The fact that Paulson said they looked at this issue and decided to essentially wipe out preferred shareholders anyway makes me think that a significant wave of regional bank failures is quite unlikely.

Treasuries will take a beating tomorrow (they're already taking a beating in Asian markets), as agency spreads tighten. Equity markets will presumably have a monster day too.

The most interesting aspect of the bailout is the promise to shrink Frannie's balance sheet by 10% each year starting in 2010. Really? Who's going to take on all that risk? The government is going to expand Frannie's balance sheet through 2009, so 10% of Frannie's balance sheet in 2010 won't be chump change. It's not a foregone conclusion that the financial sector will be fully rehabilitated by then. And I can't imagine that foreign central banks or SWFs would be too wild about assuming even more credit risk associated with the US housing market. I understand the desire to credibly commit to an exit strategy, but without more details, this commitment can hardly be considered credible.