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.
FHFA implies Freddie Mac will be profitable in 2011
Nov/104
On October 21st, FHFA released projections showing a range of possible additional draws from the U.S. Treasury required by Fannie Mae and Freddie Mac. The report was interesting because it included projections about the companies’ future revenues, expenses and net income. Although the projections are not detailed by income statement line item, they do imply that Freddie Mac will be profitable in 2011 and Fannie Mae will be profitable in 2013 in the base case scenario.
How do you conclude Freddie Mac will be profitable in 2011?
In the FHFA’s projections, the regulator shows a chart projecting future draws from the Treasury for each company. Here’s Freddie’s chart:
By focusing on the base scenario (or Scenario 2 in the chart), we can see that the FHFA projects Freddie Mac to require a $10 billion draw from the Treasury in the 2nd half of 2010, a $3 billion draw from the Treasury in 2011 and no draws in 2012 and beyond. The draws included payments made back to the Treasury for the Zombie Dividends* on the Treasury’s senior preferred stock, which has the usury rate of 10%. The draws from the Treasury are equivalent to Net Income Available to Common Shareholders.
“Net Income” is more useful than “Net Income Available to Common Shareholders” in determining whether Freddie Mac is a viable entity because it is not obscured by the Zombie Dividends paid to the Treasury. I reviewed the reasons why the Treasury should reduce the dividend rate on its GSE senior preferred stock in previous articles.
| 2H10 | 2011 | 2012 | 2013 | |
| Previous cumulative draw from Treasury | -63 | -73 | -76 | -76 |
| Net Income | -7 | 4 | 7 | 7 |
| Treasury Zombie Dividends | -3 | -7 | -7 | -7 |
| Net Income available to Common Shareholders (i.e., current draw from Treasury) | -10 | -3 | 0 | 0 |
| Cumulative draw from Treasury | -73 | -76 | -76 | -76 |
Using the similar information for Fannie Mae, the FHFA implies that Fannie will turn profitable in 2013.
How can you say Freddie Mac will be profitable but still require draws from the Treasury?
I am most focused on whether Freddie Mac can report profits before dividend payments to the Treasury. I view the net income line item of Freddie Mac as the best indicator of the profit earning capability of the corporate entity. I view the senior preferred stock issued to the Treasury as an expensive form of capital that can be restructured if the underlying company is profitable. For example, if Freddie restructured the Treasury’s stake in a similar manner to the AIG restructuring, the Treasury’s senior preferred would be converted in common stock and the Zombie Dividends would be eliminated.
What happens if the scenarios in the FHFA’s projections are too optimistic?
If anything, Freddie’s results might be better than the base case scenario of these projections because the assumptions behind these projections are conservative. Here are the possible areas of conservatism:
1) Zero growth in credit guaranty business – Although growth in this business has been negative single digits for the past year, this will not always be the case. With the housing market weak, mortgage debt outstanding has been falling. Plus, the FHA has recently raised prices, so I would expect for more market share for the GSEs in the short-term. The private-label mortgage securities is years away from becoming a competitor again. Growth in this business will resume with the continued recovery in the housing market.
2) No additional retained portfolio business – Although this business is mandated to shrink, I believe this assumption is more aggressive than the mandated decline in the mortgage portfolio. The portfolio is the main way the GSEs are generating revenue right now. These revenues are offsetting the losses in the credit business. I think it is foolish to shrink this business since the FHFA itself has said most of the losses came from the credit business.
3) No recognition of Deferred Tax Asset value – Based on the limited information in the projections, it does not appear as though the GSEs are given credit for a revaluation of their deferred tax-asset once they demonstrate a return to sustained profitability. Recognizing this asset will create capital in the near-term to allow an accelerated payback to the Treasury.
4) 5% drop in ABX and CMBX – This assumption has already proven false since we know these markets have been strong since the June 30, 2009 start of the projections.
5) Regulator has incentive to be conservative – Government projections have been consistently conservative coming out of the financial crisis. No one at the FHFA has any desire to raise expectations and have to reverse course down the road.
Conclusion
Fannie and Freddie are not endless black holes of losses. The total loss is becoming clear with passage of time. Eventually, the Treasury may get paid back for its capital investment into the companies. Profitable companies with poor capital structures lead to restructuring opportunities.
The point of this article is there a potential restructuring opportunity in Freddie Mac’s capital structure because the corporate entity will turn profitable in 2011. The potential reform of Freddie Mac and Fannie Mae will be near impossible as liberals want a full nationalization of the companies and conservatives want complete privatization. Neither scenario is pragmatic. The clearest path is to do no damage to the housing market and modify the current form of Fannie and Freddie. This is the path of least resistance politically and the least risky option economically.
Possible options for modifying Fannie and Freddie are to improve their business practices: 1) prohibit low doc and no doc lending, 2) prohibit investment in private label mortgage securities, and 3) give the FHFA authority over both housing goals and safety and soundness with a priority on safety and soundness.
Disclaimer – Please do not buy the common stock because you read this article. I believe the common stock does not have much upside because 1) the Treasury owns an 80% warrant on both companies, 2) there is a potential for additional dilution through a preferred for common swap to restructure the Treasury’s senior preferred stock, and 3) one or both of the GSEs could be put through receivership and wipe out common shareholders entirely.
* – Zombie Dividends – I call the dividend payments on the Treasury’s senior preferred stock Zombie Dividends because Treasury Secretary Paulson wanted the GSE’s dead at the time he put them into Conservatorship. He forced them to pay a 10% dividend rate to the Treasury on its senior preferred stock investment. No other financial institution has had to actually pay to the government a 10% rate like the GSEs have. The commercial banks pay a 5% rate on the TARP preferred stock. AIG initially had to pay a 10% rate, but it was restructured into a non-cumulative preferred stock and AIG Board of Directors has chosen not to pay the dividend since early 2009.
Disclosure – long Freddie Mac preferred stock and Fannie Mae preferred stock
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
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