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.