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.
Realtors Request Reduction in GSE Senior Preferred Dividend
Aug/102
Vicki Cox Golder, the President of the National Association of Realtors, sent a letter to Treasury Secretary Timothy Geithner requesting a retroactive reduction in the preferred dividend rate that Fannie Mae and Freddie Mac must pay the Treasury. The NAR argues that the high dividend rate is delaying the housing recovery, isn’t fair compared to the terms of the bailouts of the commercial banks and AIG, makes no sense to have negative compounding work against the GSEs.
What do you think of the NAR’s letter. How do you think Treasury will respond? Please post a comment.
The complete text of the letter follows:
August 13, 2010
The Honorable Timothy F. Geithner
Secretary
Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220
Dear Secretary Geithner:
On behalf of the 1.1 million members of the National Association of REALTORS® (NAR), I am writing to urge you to reduce, on a retroactive basis, the dividend rate on senior preferred stock issued to the U.S. Treasury Department in exchange for contributing capital to Fannie Mae and Freddie Mac to assure that they maintain a positive net worth.
The National Association of REALTORS® (NAR) is America’s largest trade association, including NAR’s five commercial real estate institutes and its societies and councils. REALTORS® are involved in all aspects of the residential and commercial real estate industries and belong to one or more of some 1,400 local associations or boards, and 54 state and territory associations of REALTORS®.
When Fannie Mae and Freddie Mac (the housing government sponsored enterprises, or GSEs) were placed into conservatorship by the Federal Housing Finance Agency in September 2008, the Treasury Department and each GSE entered into a contract providing for an initial $1 billion issuance of senior preferred stock with a 10 percent quarterly dividend, including warrants representing ownership of 79.9 percent of each GSE. Pursuant to the contracts, additional preferred stock has been issued in recent quarters as Treasury provided additional capital to each GSE to maintain their positive net worth. The agreements also provide for an additional quarterly fee starting in 2010.
Recent news reports have highlighted the 10 percent dividend that the GSEs are required to pay to the Treasury Department on the preferred stock. This dividend is twice the amount charged to banks that received assistance under the Troubled Asset Relief Program (TARP) and more than other firms have been required to pay in exchange for federal support. The Treasury-GSE contract imposes what we think is a punitive dividend that works as an unnecessary drag on the housing and economic recovery. The required dividend should be significantly reduced for a number of reasons.
First, the GSEs are working assiduously to reduce their losses, as they should. But the unintended consequence of their imposing high fees and very tight underwriting standards is to delay the housing recovery. NAR supports strong underwriting standards. In fact, NAR went on record, starting in 2005, at the beginning of the current crisis, warning about predatory lending, including the payment option adjustable rate mortgages and the “teaser” rate 2/28 and 3/27 mortgages that doomed so many homeowners to failure. We now just as firmly believe that the pendulum has swung too far and potential homeowners who are reasonable credit risks are too often unable to find a fair and affordable mortgage. As noted in one recent article, the GSEs’ current book of mortgage business is “pristine.” We think that achieving a pristine book of business means that the GSEs are falling short of their mission to maintain a liquid residential mortgage market, throughout the nation, that serves a wide range of borrowers, including qualified low- and moderate-income families. Reducing the current punitive dividend will enhance their ability to eliminate their losses, which will be further enhanced as the housing markets continue to stabilize and recover. This will give the GSEs the flexibility to adjust their underwriting standards to take into account reasonable lending risks, which will benefit the consumer and the entire economy, without undue risk of additional cost to the taxpayer.
Second, minimizing the amount of preferred stock held by the Treasury Department will make the challenge of restructuring the GSEs easier. One of the thorniest problems will be how to handle the amount of outstanding preferred stock held by the Treasury Department. From today’s perspective, it is hard to imagine how the capital infused into each GSE can ever be repaid. But whatever the solution, it will be easier if the obligation of the GSEs is not artificially increased by imposing the current punitive dividend rate at a level not imposed on banks or other firms, such as A.I.G., receiving government financial support.
Finally, it makes no apparent sense for the Treasury Department to transfer amounts to the GSEs so they will have enough money to pay the dividend back to Treasury. If the GSEs were not required to pay the 10 percent dividend, which significantly increases each of their quarterly losses, it would reduce the amount of additional capital Treasury is called upon to provide to them. The problem is exacerbated because a growing amount is necessary to pay the dividend on amounts received in order to pay earlier dividends. The “miracle” of compounding in this case has become a nightmare that is creating a permanent drag on the ability of the GSEs to fully achieve their mission. It would make more sense to charge the GSEs an amount equal to the Treasury borrowing cost, or the borrowing cost to the GSEs based on the current federal assurance that they will maintain a positive net worth. Both of these amounts are far less than 10 percent.
The interest of the National Association of REALTORS® in the relative financial health of the GSEs, in receivership, is based on the desire of our members for robust real estate and mortgage markets that recover as quickly as possible to assist the nation as it regains its footing after the worst economic downturn since the Great Depression. Regulators have many enforcement tools and the duty to ensure that finance corporations comply with laws, regulations, and sound underwriting. However, with respect to the GSEs, it appears that government policy has imposed a dividend rate and capital structure that singles them out for particularly onerous treatment. This strikes us as misguided at best and destructive to the housing market and economy at worst.
As you know, NAR does not defend past GSE practices that resulted in the conservatorship and recommends their total restructuring at the appropriate time. Eliminating a punitive dividend is a step that should be taken now, regardless of how the GSEs may be restructured in the coming years. NAR’s proposal for their restructuring is founded on eliminating the prior private profit and public loss structure, which was inherently flawed. We believe that it is the mission of the GSEs that must be protected, not their structure. For the benefit of homeowners, home buyers, renters, and the entire economy, the nation must have a way to assure the flow of capital to the mortgage market, regardless of the state of the housing or mortgage markets or the overall economy. The path out of receivership that achieves this result will be easier if the contract with the GSEs is amended to minimize the amount of preferred stock held by the Treasury Department.
Accordingly, NAR urges you to reduce, retroactively, the current punitive dividend rate now imposed on Fannie Mae and Freddie Mac, which together with the Federal Housing Administration, currently make possible the vast majority of mortgage lending. Doing so will speed our nation’s recovery and facilitate the movement towards a permanent GSE reform solution. If you would like additional information or an opportunity to discuss our concerns, please contact Jeff Lischer, NAR’s Managing Director for Regulatory Policy, at jlischer@realtors.org or 202.383.1117.
Sincerely yours,
Vicki Cox Golder, CRB
2010 President
National Association of REALTORS®
cc: Edward J. DeMarco, Acting Director, Federal Housing Finance Agency
So Where is GSE Reform Going, Anyway?
Jan/101
by Robert W. Zimmer
This Reuters article is the rare GSE journalist piece that calls it like it is. Let’s review the options laid out and see what’s what.
In religious wars, there are no innocent bystanders. This is certainly true for the multi-year tussle over the GSEs (Fannie Mae/FNM, Freddie Mac/FRE) and how they might fit or not fit in the US economic fabric going forward—and trust me, almost every journalist has an ax to grind one way or the other. In their heyday the GSEs were so big, so popular, and so powerful, that they swept skeptics and opponents out their way with ease—creating long-lasting enemies, including among the press.
Thus it is hard to find an unbiased viewpoint. Many journalists openly root for the GSE concept to fail and never raise its egotistical head again. Others take the contrarian view for sport. But finally there’s a piece that lays it out, with no agenda, and no ax. Let’s go over the Reuters piece in some detail.
Reuters: “That timeline (the unlimited backstop announced Dec 24) gives the Obama administration time to figure out what to do with the two entities since any changes are politically difficult and most analysts see the process taking years.”
Analysis: Dead on. The complexity of the secondary mortgage markets, combined with fear of yet-to-come exploding Option ARMS and weakening CRE markets, means there is no rush to “resolve” the GSE model legislatively. Washington policymakers want low interest rates and more modifications, and the conservatorship model is delivering them.
Reuters: “FULL NATIONALIZATION -This might be the easiest option and would return the companies to their origins as a government tool to nurture the housing market. Some analysts see the Obama administration’s Christmas eve move as a signal this is the direction they are leaning, but top White House economic adviser Lawrence Summers told the Wall Street Journal in late December “that certainly would not be the direction I would expect.” “
Analysis: Correct again. The “public option” didn’t work in the health care arena, and it won’t work here, especially as Republicans will undoubtably gain seats in the 2010 elections. And no one wants to further balloon the US budget deficit, which would happen if the GSEs were to be 100 percent nationalized. (Investors owning 20.1 percent of the companies, take heart! The US government can’t afford to take you out.)
Reuters: “PRIVATIZATION WITH PAYMENT FOR INSURANCE – Policy-makers might return the companies to investors and offer to insure Fannie Mae and Freddie Mac investments.
Washington could charge the companies a fee to underwrite their debt and some of their mortgage securities as a way to nurture the housing finance sector without standing squarely behind the companies. This idea, aired by Federal Reserve Chairman Ben Bernanke, would be akin to the Federal Deposit Insurance Corporation’s protection of banks.”
Analysis: Yes, an idea in play. This option recognizes that no one will ever believe going forward that the government wouldn’t step in again in times of debt market crises. So why not make the GSEs (and their shareholders) pay for the backing?
Reuters: “COOPERATIVES WITH LOOSE GOVERNMENT TIES – Fannie Mae and Freddie Mac could be run by the companies that sell them home loans. In such a cooperative arrangement, Fannie and Freddie would focus on long-term, stable business rather than maximizing profits. The federal government might still offer to insure the companies against the most catastrophic losses. This arrangement could be akin to the Federal Home Loan Bank system where a dozen regional lenders are jointly and severally liable for any one member’s losses and the federal government acts as guarantor of the entire system.”
Analysis: Dead wrong. The capital dedicated to cooperatives is not viewed as sufficiently flexible to support a dynamic mortgage market. More importantly, constituencies such as the Realtors and small bankers use the GSEs as a bulwark against the ever-larger, Federal-Reserve-leveraged, TARP-assisted Wall Street banks (does anyone believe THEY wouldn’t be bailed out again in a debt crisis?) that increasingly control the US mortgage market origination business—and these constituencies won’t tolerate the big banks controlling Freddie and Fannie via a coop model.
Reuters: “UTILITIES MODEL – Just like power and water companies that provide vital services, Fannie Mae and Freddie Mac could be run as private entities that have strong government oversight. The companies would aim to turn a profit and would have no government backing, but a conservative board would set earnings payments and customer fees.”
Analysis: Can’t rule this out. Stronger government oversight would have saved the GSEs from over-extending themselves in the bubble years, and a controlled ROE wouldn’t be the end of the world. And even guarantee fees could be subject to public rulemaking.
Reuters: “PRIVATE MORTGAGE-FINANCE COMPANIES – Although Fannie and Freddie are in government hands, their regulator is still trying to keep their shares trading. The agencies could emerge as large mortgage finance companies that bundle home loans for investors and raise funds in the traditional capital markets. Without government ties, though, the companies would not have lower funding costs and so would not enjoy the competitive advantage they do now. The federal government would also lose one of its most powerful tools for helping low-income home buyers. GAO said privatizing or terminating Fannie Mae and Freddie Mac would disperse mortgage lending and risk management through the private sector.”
Analysis: Not a chance. Full privatization would result in mortgage rates rising across the board by 50-100 basis points, and long-term, fixed-rate mortgages would be more difficult, if not impossible, to obtain. How many politicians want to get in front of THAT wagon? As for the GAO’s optimism of the private sector filling the space…really? Last time we checked, those guys checked out at the first sign of market instability. Anyone who has worked a day in finance knows that pure financiers are herd animals, which works well in most finance markets, but not the mortgage one.
Reuters: “COVERED BONDS – Covered bonds could become a mortgage finance tool to rival the influence of Fannie Mae and Freddie Mac. Unlike traditional mortgage-backed securities, which are frozen blocks of home loans, covered bonds allow banks to manage a dynamic pool of mortgages. This financing tool is popular in Europe but has a weak foothold in the United States because of regulatory constraints and the competitive advantages of Fannie Mae and Freddie Mac. The fate of those companies will have a direct impact on the future of covered bonds. “
Analysis: Covered bonds certainly have a place in the market going forward, but for reasons beyond the scope of this article, they can’t replace the securitization and retained portfolio model of the GSEs entirely. They will supplement, not replace, the function of the GSEs.
Conclusion: The Reuters piece is an excellent piece of reporting. With an overlay of basic political analysis, we can further narrow the scope of the ultimate options that will be debated by policymakers in Washington. And someday—believe it or not—the religious wars over the GSEs may actually reach an end. And we’ll all be better off for that ending.
Robert W. Zimmer is Principal at TVDC, a Washington-based financial services consulting firm.
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.
Make Fannie’s Deal No Worse Than TARP
Aug/090
Given Freddie Mac’s recently report profitable 2nd quarter earnings report, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.
Reasons to Change Fannie and Freddie’s Deal with the Treasury
1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut 4 weeks before TARP.
2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson.
6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock. It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios.
9. GSE preferred stock is still primarily owned by small banks. When dividends are restored, the value of the preferred stock will increase by 10x. This will add approximately $30 billion in restored capital to the commercial banking industry. If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.
Terms to Change
1. Lower Preferred Stock Coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point. We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.
The GSEs deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.
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