When discussing the likelihood that Fannie Mae and Freddie Mac would go under, the NYT dismissed the importance of the plunge in their stock prices and told readers that "the insurance premiums that are paid by the buyers of the debt securities issued by the companies declined significantly on Friday, a sign that the markets do not believe the companies are on the brink of failure." It then reinforced this assertion with a quote to this effect from the noted expert on financial markets, New York Senator Charles Schumer. The NYT is wrong on this point. Treasury Secretary Henry Paulson has made it clear that the government will bail out Fannie and Freddie's creditors in the event that the companies go under. This means that the premium on the debt is not a good measure that the markets attach to the probability that the companies will collapse, since they expect the federal government to repay the debt if the companies can't. The price of credit default swaps is an especially bad measure in such cases. The deal that the Fed arranged to have Bear Stearns taken over by J.P. Morgan did not constitute a technical default and trigger any payments. If investors anticipated a similar outcome with the collapse of Fannie and Freddie, there would be no reason for them to buy credit default swaps to insure their loans.
--Dean Baker
