This is actually fairly complex. It starts with he fact that there is a possibility that the GSEs may reduce or suspend dividends because of their losses, which is pretty straightforward: No profit, no dividend.

However, it ends up creating some complex tax and cash flow issues for traders that could have triggered rampant short selling of the stocks.

In order to to a normal “non-naked” short sale, you have to borrow a stock, pay a fee to the owner, and you sell that stock now with the promise that you will buy later and return to the lender.

Most of the shares so lent are held in brokerage margin accounts where the original purchaser of the stock would borrow money from the brokerage to cover some of the purchase price of the shares, which increases the upside and downside possibilities of the stock (if you put 25% down on purchasing a stock, and the stock makes 25%, you make 100% profit, as opposed to 25% if you paid 100% down).

However, dividends create an incentive not to keep stocks in margin accounts. The buyer does not get dividends, but instead gets payments-in-lieu of dividends, which are treated as ordinary income, and taxed more heavily.

So as an corporation cuts, or eliminates, its dividend, as Fannie Mae and Freddy Mac seem likely to do (see first ‘graph), people are more likely to put their shares in margin accounts, which makes more shares available for people to short, and hence, makes it easier more people to short the stock.

The SEC does not want this to cascade into a death-spiral for the 2nd and 3rd largest borrowers in the world, so they issued an emergency rule to restrict short selling.

Everything clear?

Good. Because I’m still confused as hell.

The SEC has just issued an emergency against naked short selling (Wiki has a good summary of what naked short selling is.)

It’s in response to the plummeting Fannie Mae and Freddie Mac stock price, but it actually probably had very little to do with that drop, there are simply too many shares of the GSEs, though it can be devastating to small and micro cap companies.

They take effect October 1, 2009, and require lenders to verify ability to pay, shorten the prepayment penalty period on expensive loans, and require escrow accounts for property taxes and homeowner’s insurance (this one cuts in a year later).

We have a whole bunch of people talking about what should be done with Fannie Mae and Freddie Mac, starting with the Wall Street Journal editorial page, which suggests that Treasury Secretary Paulson put the GSE’s in receivership.

Of course, the WSJ has always hated Fannie and Freddie, because they are sort of public, which, by the standards of their Neanderthal sensibilities, is evil, so this position is far from a surprise.

Of more significance are the statements of William Ackman, who manages a hedge fund, and made big bucks short selling the monoliner insurance companies.

He’s betting against the GSEs:

Ackman, 42, has his own plan that would see Fannie Mae raise about $86 billion in capital by giving investors in $750 billion of senior unsecured notes 90 cents on the dollar in debt of a new company, with the balance in equity. Investors in Fannie Mae’s $11 billion of junior debt would get warrants, while common and preferred shareholders would get nothing, according to Ackman.

Not surprisingly, when talk like this is coming from Wall Street bigfoots, Moody’s cut the financial strength ratings of both GSEs to B-, and not surprisingly, their stock dropped by double digits today.

In my humble opinion, the upper management and stock holders need to lose, and lose big, or we will be back here in a few years.

Protecting share holders and upper management should not be a part of any bailout.

It looks like they are going to fix some things, particularly pre-payment penalties on abusive loans, requiring escrowing taxes, etc.

It’s not much, but it’s a start.