The latest rumors, likely started by hedge funds that are short the securities, suggest that Fannie Mae and Freddie Mac are insolvent, PIMCO has cut off doing business with Lehman, mortgage losses will exceed $1 trillion, and so on. Do people really believe one twelfth of all mortgages will fail? All of these rumors are repeated by the media, horrifying investors, who sell off their holdings into a falling market out of fear that prices will go even lower. What's real and what is hysteria?

Let's start with a simple case. The media reported that PIMCO had ceased trading with Lehman, forcing Bill Gross of PIMCO to appear on television to deny the story. One of our people called a friend on the financing desk at Lehman and was told he was actually processing trades with PIMCO that very minute the "news" was broadcast on television. How does a manifestly untrue rumor like this get started? Likely, the same way false rumors undercut Bear Stearns. The market is rife with absolutely false rumors maliciously planted with the media that is intended to undercut the ability of firms to roll over their liabilities. But it is irresponsible that such reports would be broadcast without verification and with the media not revealing the source of patently false stories. The SEC has announced an investigation. Hopefully, it will be a serious effort. Starting or spreading such rumors is no better than screaming fire in a theater.

The situation with Fannie Mae and Freddie Mac also reflects sheer hysteria. For a firm to fail, the market must stop lending to that firm, so it runs out of cash. It is the inability of a firm to finance its business that constitutes a failure and that results in a bankruptcy. So how does one rationalize the possibility of a failure with the fact that Fannie Mae issued a $3 billion 2-year note last week at a slightly higher yield of 75 basis points above Treasuries, versus paying 65 basis points earlier? And if the GSEs are too big to fail so they would get bailed out, then their debt will be paid and the market has no reason to shun their debt issues. In fact, the spread earned by Fannie Mae, the difference between the rate Fannie pays and the rate Fannie earns, is now at all time record levels! New investments are extremely profitable. So, how can Fannie and Freddie fail?

Fannie and Freddie have roughly $80 billion in capital. As their critics note, this capital base supports a huge asset base of $1.65 trillion, or about $6 trillion including mortgage guarantees. So, both firms are quite leveraged. However, their assets provide a very strong, stable flow of cash and their default rates have been quite low. Indeed, net interest income is rising very rapidly for both firms, as noted above. Critics of the GSEs focus on "fair value accounting," which suggests a capital deficit. Those losses are mostly due to the decline in the market value of their securities, not to defaults, a distinction these critics choose to ignore. Most of the mortgages they own continue to pay interest and principal each month. If the GSEs wanted to rebuild capital and ignore public policy needs, they could stop lending and monthly principal payments would provide more than $100 million in cash each month. But if they were forced to sell off their mortgage securities under current market conditions, they would suffer large losses. Indeed, that's what the hedge funds would love to force them to do. But there's not a reason in the world for them to voluntarily commit suicide to suit those hedge funds. Instead, they continue to issue new debt at very favorable, low interest rates and they have sold preferred stock to raise capital and take advantage of the wide interest rate spreads available to them, while helping the housing market to recover.

The media keeps talking about what the government can do to help Fannie and Freddie survive, which stokes fear in the mind of investors. However, both firms continue to be able to borrow money at very competitive yields. Still, it would be beneficial for the government to take steps to comfort investors and calm the markets, as the government is now doing. Indeed, Senator Dodd, head of the Senate banking Committee, made exactly that point on Friday. And Treasury Secretary Paulson's statement indicated the Treasury would support Fannie and Freddie in their current form and both held adequate capital. Investors will get this message sooner or later. And if the government really wants to calm the market, they could purchase a sizeable preferred stock issue, which would increase the capital base at the GSEs, would be very profitable to the government, and likely be accretive to Fannie and Freddie. Only the hedge funds that are short would lose.

Late on Friday, stories appeared that Freddie and Fannie did have access to the Fed's discount window. The stocks rallied sharply on the story and sold off after it was reported that no formal press release supported this news. Rather, the story was based on a conversation with Richard Syron, CEO of Freddie Mac. What was missing was that neither Fannie nor Freddie needs to use the discount window! Why would they borrow from the Fed when they can borrow easily directly in the credit market? Over the weekend, it was announced the discount window is now available to the GSEs. Although borrowing at the 2.25% discount window rate is very cheap, so they will be tempted to tap the window, the GSEs should continue selling bonds publicly, if only to demonstrate to investors that they can tap the public markets whenever they wish.

Given all of this, how are we managing our holdings? We are not selling either Fannie or Freddie. These stocks will remain very volatile, especially as long as malicious short sellers spread false rumors at every opportunity. But, we expect these companies to become very profitable over time and for their stocks to recover. I wish I could have foreseen some of this panic, sold off these holdings earlier, spared our investors some of the fear we know they are now experiencing, and been able to buy the shares back now at much cheaper prices. The market's panic went well beyond anything we consider reasonable. That's the reality. Nevertheless, the market's panic will not destroy these companies, in our judgment, when the government needs Fannie and Freddie to help the residential housing market recover and now states publicly they will assist them in the unlikely event they actually need assistance. So while a cast iron stomach may be needed to cope with the volatility, it is our judgment that both companies will prosper mightily in a healthier economy that will emerge in due course. So, it is a time for patience.

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