Hank Punts on First Day of Pro Football Season

Author: Bob Eisenbeis, Post Date: September 8, 2008

Treasury and the Federal Housing Finance Agency (FHFA) placed Freddie and Fannie into conservatorship, replaced existing management, suspended dividend payments on outstanding equity and preferred stock, and promised injections of new capital in the form of senior preferred stock with warrants.  The actions are designed to maintain the flow of funds to housing and to stabilize financial markets while providing protections to the taxpayer.  There are many good things about the structure of the deal.  For example, the arrangement does keep Freddie and Fannie in the business of supporting the mortgage origination business in the short run, by expanding slightly their ability to increase their mortgage-backed securities business.  It also calls for shrinkage in their portfolio investments by 10% per year, starting in 2010, until they decline from a max of approximately $850 billion to $250 billion.  They are to suspend all lobbying efforts, and presumably this will mean campaign contributions as well.  Finally, it is clear that existing preferred and common stockholders will experience significant, if not 100%, loss of their investments. 

But when one delves more deeply into the plan there are many problems and questions.  What Treasury clearly has done is punted the actual dirty details of handling these two hot potatoes to the next administration, with no clear exit strategy nor any practical solutions to the fundamentally flawed business model that Secretary Paulson referred to on several occasions during his press conference. 

What are some of the troubling aspects of the deal?  First, Treasury has agreed to provide a liquidity facility which will acquire newly originated mortgage-backed securities, presumably from Freddie and Fannie.  The facility will expire at the end of 2009, so what happens if it is still needed?  Mostly likely it will be extended by the next Congress, with no end in sight. 

Second, the creation of the facility means that Freddie and Fannie will be able to launder new mortgage debt to the Treasury, in addition to increasing their own portfolios in the short run, with no clear idea of when and how the program will be phased out. This will be at a favorable rate (only 50 basis points over LIBOR) and in addition to whatever opportunities exist to borrow from the already authorized Federal Reserve Discount Window.  The arbitrage possibilities here are significant. 

Third, the conditions under which the preferred stock injections will take place are unclear.  Secretary Paulson indicated that Treasury initially will receive $1 billion in preferred stock plus warrants, just for providing the facility.  It also means that funds would be provided on an as-needed basis to enable Freddie and Fannie to maintain positive net worth.  Assuming that losses exceed the value of common equity and perhaps even that of preferred stockholders, any positive net worth will be solely due to the government’s preferred stock interest, on which the institutions will have to pay a 10% dividend.  Earnings on a shrinking business will have to be positive for a long time before there is any value to existing equity holders or to the government through the warrants.

Fourth, the accounting here is critical in terms of when and how losses are recognized and as to the timing of any injections of public monies.  It is not even clear how the preferred stock will be valued.  Given the current state of Freddie and Fannie’s books and the negative implications that Morgan Stanley’s analysis has suggested with regard to the calculation of the value equity, one can’t have a lot of confidence that there will be much transparency when it comes to treatment of the capital injections or the sharing of losses. 

Fifth, while it appears that the intention is that Freddie and Fannie will emerge from this nationalization much smaller in size, this is not necessarily the case with respect to their guarantee programs.  Nor do we have any clues as to how their flawed business model will be repaired.

Sixth, a lot of people and institutions have purchased preferred stock and other debt on the basis of representations of management and others about the financial condition of these institutions.  Should lawsuits arise or possible fraud allegations be raised and sustained, then one wonders about the status of such claims relative to those of the government.

Left to be determined is what the final structure of these institutions will be, how these institutions will relate to private market sector alternatives, and when and how Treasury exits from its mortgage and mortgage-backed securities programs.  These are all issues that will conveniently take some time to identify and address and thus be punted to the next administration and to the Congress.  Regardless, it is safe to say that Freddie and Fannie are unlikely to be returned to the private sector any time soon, if ever.  This is especially the case given the politics that are likely to surround these institutions’ role in housing.  In the meanwhile, debt holders can breathe easier, as can mortgage originators.  The same can’t be said for preferred stock or equity holders.

In the end, this whole problem is likely to dwarf the thrift crisis of years ago in terms of the cost to the taxpayer, and it is totally a consequence of misguided housing polices.  It is not of Secretary Paulson’s creation.  It is a problem that has been incubating for a long time and one that was predicted by many observers.  Equally important, Congress, HUD, and Freddie and Fannie’s regulators are mainly responsible for the creation of these institutions, for their flawed business model, and for their unconstrained moral hazard behavior.  Congress and HUD mandated certain goals and objectives often formulated in terms of market shares of certain products of primary markets, just at the time that more and more bad loans were being made.  Congress, in particular, both allowed and refused to limit the lobbying efforts of Freddie and Fannie while gladly taking campaign contributions when offered.

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