Clarity and objectivity by James Rickards

Lest we forget how we arrived here:

Once, the strength of a bond was based on the reputation of its issuer.

But a change began in 2008, as Fannie Mae and Freddie Mac verged on bankruptcy, and legislation was rushed through the US Congress to restructure them. The political importance of these institutions created a new world, one in which a bond’s performance is determined by the reputation of its holders.

Next week the US Treasury hosts a major conference to discuss Fannie and Freddie’s future. But to understand how they changed the rules, we must return to the circumstances of their restructure. Such things are normally straightforward. Equity is wiped out, assets are revalued and the gap in the balance sheet is uncovered. Bondholders take a “haircut” – meaning a lower than expected return – or a principal reduction. Some principal converts to equity, management is replaced; voilà, life goes on.


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