Hank Paulson Isn’t Operating His Financial Doomsday Machine
Sep/110
Current events in the financial markets have eerie similarities to 2008: looming defaults of large formerly riskless debt issuers, toxic debt that needs to be written down, elevated LIBOR rates, etc. The major difference is the current U.S. Treasury Secretary is committed to keeping the financial system functioning.
We all watched in horror as the events of September 2008 unfolded. Investors had been nervous all summer about the stability of the major financial firms. As we entered September, there were a couple of lingering issues (Lehman Brothers and the GSEs), but both had reasonable outcomes. In fact the markets were not signaling financial distress as the CBOE’s VIX Index entered the month at a reasonable 20.65.
First, Lehman Brothers was clearly in need of capital given its massive real estate exposures. Although it seemed unlikely they’d be able to raise additional capital, it was reasonable to assume a controlled sale of the firm similar to the Bear Stearns sale in March 2008 would transition the business to an acquirer. Since Bear Stearns bondholders were made whole, the financial system kept chugging along. The same could happen with Lehman.
Second, Fannie Mae and Freddie Mac were under pressure mainly because of their mortgage exposure and their political opponents sensed weakness and continued to pressure the companies through the media. The chatter was the GSEs were starting to pay higher rates on their weekly discount note auctions, but this was a not event because both companies had $700 billion of unencumbered debt that any repo lender would take as collateral. Plus, the situation seemed to be resolved over the summer with new powers for the Treasury Secretary to be able to inject capital into the firms, which he said he didn’t intend to use.
Instead of riding through a tough market, Hank Paulson turned on his Financial Doomsday Machine. Economist Anatole Kaletsky coined the term in a September 18, 2008 op-ed in The London Times:
“It is clear that most of the actions taken recently by regulators and governments have exacerbated the crisis. Instead of using his Government’s unlimited financial firepower to defend the financial system, Henry Paulson, the US Treasury Secretary, turned his guns on his own side, wiping out long-term investors who tried to support leading financial institutions, while rewarding speculators who tried to bring them down.
Mr Paulson was activating a financial Doomsday Machine, driven by a chain reaction of actions by stock market speculators, regulators, credit-rating agencies and accountants. The details of this mechanism are complex, but the gist is simple – if a bank’s share price falls below a critical level, its credit is downgraded; it has to sell assets at fire-sale prices; this further weakens its capital, leading regulators to question its solvency; this drives down its share price and the vicious circle takes another turn. What Mr Paulson did ten days ago was to hand to stock market speculators the key to this Doomsday machine.
This may seem an outlandish accusation – especially against a supposed financial mastermind who was a chairman of Goldman Sachs – but consider the event that triggered the market attacks on Lehman Brothers, AIG and HBOS. They all followed Mr Paulson’s punitive decision on September 7 essentially to expropriate the $20billion of capital injected into Fannie Mae and Freddie Mac by shareholders over the previous 12 months. Long-term shareholders made these investments, with the encouragement of the US Government, to stabilise Fannie and Freddie. Meanwhile, a host of short-term speculators were selling these same securities, convinced that the two companies would be driven into bankruptcy.
By rewarding short-sellers while wiping out investors who reckoned on a long-term recovery that would restore the mortgage giants to profitability, Mr Paulson sent the clearest possible message to financial markets around the world. Any investor who puts money into a US financial institution that might run short of capital would have it expropriated by the US Government. On the other hand, sellers of US bank and insurance shares would be richly rewarded if they could destabilise any financial institution sufficiently to force it to turn to the Government for help.
In the past few days the same pattern of perverse incentives has been repeated in the bankruptcy of Lehman and the “rescue” of AIG. In both cases, Mr Paulson decided to wipe out investors banking on a recovery while rewarding destabilising short-sellers.
The key question is whether this scorched-earth strategy will become a firm principle of Mr Paulson’s responses to future attacks on US financial institutions.”
Paulson committed the largest financial policy mistakes since the Great Depression by placing the GSEs into conservatorship and forcing Lehman Brothers to declare bankruptcy. Paulson had destroyed the potential for a private recapitalization of the banking system with his actions. The financial system quickly froze. Money-market funds stopped purchasing new commercial paper. AIG needed a massive bail-out two days later. Goldman Sachs and Morgan Stanley needed to obtain bank charters over a weekend. All of these events lead to the Great Recession as Main Street American consumers and business people started conserving cash and restrained their spending.
Back to the events of today, the current U.S. Treasury Secretary, Tim Geithner, is on a different course from Paulson circa Labor Day 2008. He was the New York President at the time and sat at the table watching Paulson make his mistakes. I see from his speeches and interviews that he will protect the financial system. I believe that he will not let major U.S. financial institutions such as Citigroup and Morgan Stanley get destroyed in a chain reaction to a default in Greece. The difference between Geithner and Paulson is why Greece will not be the equivalent of Lehman Brothers for the U.S economy.
Updated Thinking on Fannie and Freddie
May/111
This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
I have owned positions in Freddie Mac and Fannie Mae (the GSEs) preferred stock since the two firms were placed into conservatorship in September 2008. The shares have been extremely volatile. In the first five weeks of the year, the various classes of Fannie and Freddie preferred stock rose in price from about 2% of face value to about 6% of face value.
There are several factors that contributed to the value increase in these positions:
1. Fannie and Freddie’s financial results are improving – Both companies have improved their operations while in conservatorship. The new loans the companies have guaranteed in 2009, 2010 and going forward will be profitable. The problem vintages of 2005-2008 are being resolved and may be fully reserved for losses. In the meantime, the companies’ mortgage investment portfolios have been very profitable and are throwing off $16 billion of cash per year at each company. I believe Freddie Mac will become profitable in 2011 and Fannie Mae is potentially within 2 years of turning profitable. I believe the regulators have acted wisely in how they’ve managed Fannie and Freddie through conservatorship. Once the companies turn profitable, the nature of the policy debate will change for the better.
2. Realization that continued existence of the GSEs makes the most sense - The Republican success in the election of 2010 makes full nationalization of Fannie and Freddie unfeasible politically. On the other hand, the private market is not capable of providing enough capital to keep the mortgage market functioning smoothly especially at the low prices Fannie and Freddie charge to accept mortgage credit risk. Evidence that the private market is not capable and/or willing to supply capital to the mortgage market is Fannie, Freddie and FHA’s combined 95% percent market share of the mortgage market since 2008. The least risky option is to continue with the current system of the GSEs but impose tighter regulation on the companies to prevent bad management.
3. Recognition that Congress will not resolve the GSE issue soon - Rationality is returning to the GSE policy debate. Cooler heads are voicing their opinions that the GSE model is not broken. We are starting to see this point made from surprising sources such as Steven Roth’s annual letter to Vornado shareholders. The problem with the GSEs wasn’t their hybrid public/private model. The problem with the GSEs was incompetent management that did not recognize the danger of low documentation loans.
4. News that the GSEs asked the Treasury to reduce the coupon on its senior preferred stock – In late January, the Financial Times ran a story saying that management at both Fannie and Freddie asked the Treasury Department to reduce the 10% coupon it receives on its senior preferred stock. Freddie Mac may turn profitable this year even after paying over $6 billion in after-tax dividends to the Treasury. If the coupon rate was lowered, then Freddie could pay back the Treasury that much faster. Plus, the fact that management asked for the reduction confirms that the companies’ financial situations are in the beginning stages of recovery.
Of course, there should be several important changes to the GSE model to protect taxpayers, such as: Fannie and Freddie should not purchase mortgage loans without full documentation of income and assets, should not purchase private label mortgage securities, should step back from the market when spreads are tight and new business cannot meet their return on capital targets, and should restrict executive compensation. A final necessary reform is a requirement that any member of the board of directors be required to purchase an amount of common stock equivalent to a multiple of their annual directors’ fees with their own cash. This would incentivize board members to provide better oversight of management. As a shareholder, I wish all of these changes had been implemented years ago.
As Freddie turns profitable and recaptures some of the capital that is artificially hidden in its accounting statements (marks on private label securities, valuation allowance on deferred tax asset and generous loan loss reserve), I believe the potential exists for them to repay some or all of the Treasury’s investment. Once Freddie regains profitability and begins to repay the Treasury, a whole new set of policy options becomes available. These new policy options would be beneficial to preferred shareholders. It has been a long road owning Fannie and Freddie preferred stock, but the Fund has made a lot of money from the positions and the potential exists for future gains. Although these positions will continue to be volatile, I continue to see several scenarios with further upside.
ICBA Calls for Restoring GSE Preferred Dividends
Mar/100
Last week, Camden Fine, President and CEO of the Independent Community Bankers Association, sent a letter to Secretary of the Treasury Timothy Geithner asking Treasury to restore the dividends on Fannie Mae and Freddie Mac preferred stock. Reading the letter, the community bankers feel like they were sold a bill of goods by Hank Paulson. It seems that Paulson’s book has enraged the ICBA, especially the fact that Paulson was proud to keep his promise to his “Chinese friends” for making them whole on GSE senior debt and MBS.
Let me know if it feels like the political rhetoric has died down regarding the GSEs.
March 12, 2010
The Honorable Timothy Geithner
Secretary of the Treasury
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220
Dear Secretary Geithner:
On behalf of the 5,000 members of the Independent Community Bankers of America I urge prompt Treasury action to remedy the status of preferred shareholders of the Government Sponsored Enterprises Fannie Mae and Freddie Mac. As the Administration and Treasury continue to control Fannie Mae and Freddie Mac in conservatorship and seek resolution to this unique GSE status, it is imperative that community bank GSE preferred shareholders are made whole to bolster capital and lending levels in this challenging financial and economic environment.
The abrupt action by then Treasury Secretary Henry Paulson to seize Fannie and Freddie through conservatorship was unjustly done in a way that needlessly crushed the value of GSE preferred shares, injuring over a thousand community banks that purchased these shares as a safe AAArated investment at the encouragement of their bank regulators. Since banks received special regulatory capital treatment for them and since banks are generally prohibited from investing in stock of other corporations, Fannie and Freddie preferred stock were important investments with full regulatory blessing.
Shockingly, Secretary Paulson fully acknowledges in his new book On the Brink that this action constituted an “ambush.” It took place shortly after he and the GSE regulators issued statements that supported the ongoing viability and capital levels of the GSEs in their current form as “shareholder-owned companies,” in order to “calm the market fears of a government takeover that would wipe out shareholders.” Now there is no doubt the government’s action was indeed an unjustified “ambush” structured in a way that continues to have detrimental consequences on many community banks that relied on the guidance of Treasury and bank regulators and were intentionally deceived on their Fannie and Freddie preferred holdings.
Americans expect and demand much better from their government and leaders. The lCBA urges the Treasury to help restore the value of the Fannie and Freddie community bank preferred share holdings to levels prior to the abrupt conservatorship of Fannie and Freddie. Preferred Fannie and Freddie shareholders should be compensated for the government’s action of eliminating all dividend payments and placing the preferred shares in a second position.
Rather than help stabilize the financial sector and boost lending, this government “ambush” further hurt banks’ capital levels, weakened the banks and reduced available credit. Such rogue changing of the rules governing preferred stock contracts also sent the entire market for financial preferred shares into a freefall, making it even more difficult for financial firms to raise needed capital. Notably, nearly $36 billion in Fannie and Freddie preferred stock was outstanding prior to their conservatorship. An estimated $15 to $20 billion was held by the banking sector and almost one-third of banks reported holdings including many Main Street community banks.
The Troubled Asset Relief Fund devoted $700 billion to help restoring financial sector credit and to increase lending with mixed use and results to date. However, if we truly want to help stabilize the financial sector, boost small business credit and economic growth, Treasury must also restore a reasonable value to GSE preferred stock so that affected banks can again increase their lending.
ICBA urges immediately restoring the dividend payments on Fannie and Freddie preferred shares and paying injured holders the amount of suspended dividends from September 7, 2008 on an estimated $20 billion in GSE preferred holdings. As the Administration works to remove the GSEs from conservatorship ICBA urges it be done in a way that will restore a reasonable value to the preferred shares. Helping restore the $15 to $20 billion in community banks capital value crushed by the unwarranted Treasury actions perpetrated on preferred shares can foster $150 billion to $200 billion in new lending as banks can leverage this capital.
Sadly, the Treasury and policymakers were forewarned of the distress and fallout that lmnecessarilv crushing GSE preferred shares would cause. For example, the attached letter dated August 271h, 2008 specifically warned of the community banks’ significant GSE preferred holdings that typically pay a fixed dividend and take priority over common stock. Unfortunately, Treasury chose to ignore the warnings when they turned the GSE preferred stock upside down when placing Fannie and Freddie into conservatorship on September 7, 2008. Mr. Paulson acknowledges in his book that he ambushed Fannie and Freddie shareholders in part to help satisfy the Chinese government, which owned billions of dollars in Fannie and Freddie bonds. Mr. Paulson notes that he called “my old friend Zhou Xiaochuan,” the head of the Central Bank of China, and China’s key financial leaders and said: “I always said we’d live up to our obligations.” ICBA believes it is now time to live up to United States obligations and help spur lending by compensating Fannie and Freddie preferred shareholders for the unjust actions of the government.
Sincerely,
/s/
Camden R. Fine
President and CEO
cc: The Honorable David Axelrod, Assistant to the President and Senior Advisor
The Honorable Lawrence Summers, Assistant to the President for Economic Policy and
Director, National Economic Council
The Honorable Eric Holder, Jr., U.s. Attorney General
The Honorable Michael Barr, Assistant Secretary for Financial Institutions
The Honorable Herb Allison, Jr, Assistant Secretary for Financial Institutions
The Honorable Barney Frank, Chairman, House Financial Services Committee
The Honorable Spencer Bachus, Ranking Member House Financial Services Committee
The Honorable Chris Dodd, Chairman, Senate Committee on Banking
The Honorable Richard Shelby, Ranking Member, Senate Committee on Banking
Interesting GSE Article at Housing Wire
Mar/100
Paul Jackson, the publisher of HosuingWire magazine, wrote an interesting article about the lack of a political solution to the GSEs.
I find this article interesting because there is a growing realization that the path of least resistence for resolving the GSEs Conservatorship is to simply allow them to exit in their current form when they return to profitability.
New LinkedIn Group for Fannie Mae Shareholders
Feb/100
I formed a new LinkedIn group for Fannie Mae and Freddie Mac shareholders. Please join the group by following this link:
http://www.linkedin.com/groups?home=&gid=2780934
The purpose of the group is for shareholders to network with each other and to discuss ways to increase shareholder value. The group is open to common and preferred shareholders of both companies.
Rebuttal to GSE Worthless Analysis
Oct/092
On Monday, the respected financial services boutique brokerage firm, KBW, published a report declaring the common and preferred shares of Fannie Mae and Freddie Mac to be “worthless.” The conclusion of the report was based on a contrived scenario where Fannie and Freddie are separated into good-bank/bad-bank entities and the future profits are diverted away from paying down the government’s ownership stake in the companies. If this scenario were to happen, it would be another huge subsidy for the big mortgage banking firms at the expense of taxpayers like you and me.
Bank Co-operative Model is a Bad Idea
Fannie and Freddie should not be restructured into bank-owned co-operatives. The brokerage report held up the FHLB System as a model for the future structure of Fannie and Freddie. The FHLB System is a poorly constructed system and is not an enviable model. The FHLB System allows the large banks to borrow money at government subsidized rates. The banks can use this borrowed money for any kind of lending they want such as auto loans, commercial loans, boat loans or even loans to foreign countries. This system has not prevented the FHLB Banks from posting large losses during the housing crisis. Another reason the FHLB System is bad is that it presents sizable systemic risks because it has no permanent capital. Members of the FHLB system can withdraw their capital on 90 days notice. In spite of nominally higher capital levels, the fact that FHLB capital is withdrawable makes the banks less stable than Fannie and Freddie. Moving Fannie and Freddie to a less stable capital structure is a bad idea.
Good-Bank/Bad-Bank Proposal Doesn’t Make Sense
Separating Fannie and Freddie into a good-bank/bad-bank as the KBW authors propose will not work because it is not a classic good-bank/bad-bank restructuring. First, in this proposal, the bad bank can’t support itself. Second, the authors transfer ownership of the good-bank to new owners. The concept of a good-bank/bad-bank split only makes sense if both entities are viable and self-supporting and have identical owners. The good-bank is a clean entity and can be more easily valued by the stock market. The bad-bank is capitalized to be self-standing and management can workout problem assets over time to realize maximum value without worrying about the timing of accounting gains or losses. The classic practical application was Mellon Bank in the 1980′s. In this report, the authors propose setting up the bad-bank as a non-viable entity from the start, and they assume a transfer ownership of the good-bank without any compensation. I submit that you can claim any financial institution in the country is worthless under the authors’ version of a good-bank/bad-bank scenario.
Holes in the KBW/GSE Model
There are multiple problems with KBW’s model that shows Fannie and Freddie having problems paying back the Treasury.
1. Bad-Bank Focus– As discussed earlier, as long as Fannie and Freddie are not separated into good-bank/bad-bank entities, they will be able to use revenue from new business to payoff the Treasury’s ownership position. Using the revenue from the good-bank will add $38 billion to Fannie and $25 billion to Freddie.
2. Double Counting Operating Expense – KBW’s model has operating expenses double counted. This adds $14 billion in expense to Fannie and $10 billion in expense to Freddie.
3. Severity Assumption is Too High – KBW uses 60% severity in its base case compared to John Hempton’s severity assumption of 45%. (BTW, the definitive analysis of the current value of Fannie and Freddie can be found in John Hempton’s series of blog postings on Fannie and Freddie.) I trust Hempton’s assumption more than KBW’s as he builds it up by vintage year. This accounts for $29 billion at Fannie and $15 billion at Freddie.
4. Mortgage portfolio run-off is much greater than mandated by Treasury – KBW assumes a run-off of the current on-balance sheet mortgage portfolio at a rate faster than mandated by the Treasury agreement. This accounts for $18 billion in lost revenue at both companies.
5. Assumed NIM is low – KBW assumed a 1% net interest margin which is low given the steep yield curve. If we assume Fannie and Freddie can keep their current margin for a three more years then revert to a 1% margin, it adds another $19 billion of revenue to both companies.
With these changes to KBW’s model, I calculate both companies can payback the Treasury:
($ billions) Fannie Freddie
Assumed shortfall from KBW model -49 -39
No good-bank/bad-bank separation +38 +25
Not double counting expenses +14 +10
Hempton’s severity assumption +29 +15
Slower portfolio run-off +18 +18
Current NIM +19 +19
New Capital Surplus +69 +48
With any model, the results are heavily dependent on assumptions. The user of a model must be well-versed in the assumptions before relying on its output. This analysis shows that by changing (and/or correcting) a few assumptions in the KBW/GSE model that the companies have plenty extra capital to pay back the Treasury, which is the opposite conclusion of the KBW report.
Another important assumption in the KBW model, which makes the GSEs’ capital positions look weaker is the assumption that they cannot raise capital from the public markets. Once the GSEs return to profitability, they may be able to raise equity to repay the Treasury.
Conclusion
The GSEs aren’t worthless until Congress restructures them and shareholders no longer have valid claims. Until Congress passes a law, the GSEs are working hard to mitigate their problem loans and to provide continued credit support to the housing market. Their income statements will flip from posting losses to reporting positive net income as we pass the peak loss years on the mortgages of 2006-2008. Freddie reported a profit in the last quarter, and it will be difficult to wipeout Fannie and Freddie shareholders once they return to sustained profitability.
Fannie and Freddie Model from Bronte Capital
Aug/091
John Hempton of Bronte Capital has written a fascinating series of articles on Fannie Mae and Freddie Mac. He models Freddie’s credit losses and revenues and comes to the conclusion that the company will earn its way to paying back the Treasury. He concludes that the way for investors to position themselves is to buy preferred stock in Fannie and Freddie.
Part I – Introduction and Where Losses Came From
Part II – Write Downs on Private Label Securities
Part III – Default Curves
Part IV – Estimates of Lifetime Defaults by Loan Vintage
Part V – Net Interest Margin
Part VI – Putting the Model Together
Part VII – Answering Criticsms
Part VIII – Risks
Not surprisingly, I completely agree with his analysis. I own a substantial amount of GSE preferred stock in Gator Financial Partners. In fact, it is, by far, my largest position.
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