September 16, 2008
Monday's Legal Times: Soothed Waters Roiled
The following is a Legal Times article that I wrote on Friday for Monday's edition. You will note that by the time the article came out, the folly of the "soothe the waters" approach had already failed -- Lehman in bankruptcy, Merrill Lynch in a distress buyout out, and AIG knocking on the government's door for protection:
The big winners of last week’s mortgage-company seizures are foreign countries, foreign investors, and Republicans. The seizure would not have happened had it not been an election year.
In late July, President George W. Bush signed the Housing and Economic Recovery Act of 2008. The act gave the Treasury, the Federal Reserve, and a new agency, the Federal Housing Finance Agency, new authority over two struggling government-sponsored entities, Fannie Mae and Freddie Mac.
Together, these GSEs, which are federally chartered, publicly traded corporations, held or guaranteed close to 80 percent of the country’s residential mortgages.
The 2008 act gave Treasury and the Fed the power to provide emergency funding to either GSE should it need funds to operate. At the time, we were told by Treasury Secretary Henry Paulson that he would not need to use the authority. (Remember his colorful “bazooka” language, that if you’ve got a bazooka in your pocket and people know it, you probably won’t have to take it out?)
We were told by the CEO of Fannie Mae and the director of its oversight agency, Jim Lockhart of the Office of Federal Housing Enterprise Oversight, that Fannie Mae had sufficient capital to meet the requirements of the agency, the FHFA’s predecessor. Both Paulson and Lockhart pointed to a successful sale in May by Fannie Mae of more than $7.4 billion in new notes.
In March, Congress had ordered the GSEs to pull out an additional $500 million to subsidize “affordable housing.” How sick could they be?
Suddenly, on Sept. 7, a Sunday, we are told that the FHFA had seized the two companies. The FHFA had taken over total control, removing management power from the companies’ boards of directors and voting power from their common shareholders. It is called a conservatorship; the FHFA is the conservator.
The two companies also had signed preferred stock purchase agreements with the Treasury. Treasury would buy $1 billion in senior preferred stock from each GSE immediately and, over time, could purchase another $99 billion apiece. With each purchase came a warrant to purchase 79.9 percent of the common stock for a nominal price. The senior preferred stock pays a 10 percent annual dividend, which will increase if not paid (which is likely). For additional cash needs, the Fed agreed to lend, short term, cash on “eligible collateral” and GSE mortgage-backed securities, and the Treasury agreed to purchase the GSEs’ mortgage-backed securities at healthy prices.
The major effect of the seizure was to prop up the value of the GSEs’ existing senior and subordinated debt holders and the securities that the GSEs had guaranteed.
The seizure also encouraged new lenders to loan money to the GSEs at lower interest-rate spreads from U.S. Treasuries. Indeed, three days after the seizure, Fannie Mae floated $7 billion in new notes. Treasury hopes that with new cash, Fannie Mae and Freddie Mac can continue to buy and guarantee mortgages and that mortgage interest rates will drift down, stimulating a depressed housing market.
WINNERS AND LOSERS
The big winners were the GSE senior and subordinated debt holders and those who hold mortgage-backed securities guaranteed by the GSEs.
The size of the GSE debt is staggering: The GSEs had floated $5.4 trillion in obligations—equal to the total amount of public debt floated by the entire federal government. With the seizure, the GSEs’ debts and guarantees were now backed by the full taxing power of the federal government.
The big losers were the GSE preferred and common shareholders, whose stock is hugely diluted and whose dividends have been suspended indefinitely. Their investments are therefore now worth a dollar or so a share, if that, down huge amounts from recent highs. Other losers probably include, and we do not weep for them, the well-paid, sharp-elbowed lobbyists who funneled $170 million a year into the hands of federal politicians.
Common shareholders are howling for two other groups to join their misery: (1) the GSE executives who took fat pay and severance checks home while running the companies into trouble; and (2) the politicians who took GSE cash and then protected the executives from repeated calls over the last five years for GSE accountability (Sen. Christopher Dodd, any regrets?).
Unfortunately, it appears that their calls will go unheeded; soothing the waters is the order of the day.
Putting names on the winners and losers uncovers that apparently the biggest winners were foreign countries, either through their state banks or their sovereign wealth funds, and the world’s investment banks. China holds a whopping $400 billion in GSE debt and Japan $230 billion; several of the oil rich countries of the Middle East hold more than $50 billion or so apiece. The largest of the world’s investment banks hold substantial amounts of GSE debt in their portfolios, right along with their holdings of U.S. Treasuries. If you read Paulson’s announcement on Sept. 7, you will note his worried references to the world’s central banks and investment markets.
In short: U.S. taxpayers may be bailing out the governments of China, Japan, and Abu Dhabi, among others.
AN ODD PUNT
Why now? Why this way? Paulson’s Sept. 7 statement provides the clues to an answer, and the answer is not pretty.
The public justification suggested that the GSEs’ balance sheets were worse than Paulson had suspected. On its face, that’s an odd public admission because it (1) discredits an administration oversight agency and a sitting director (Lockhart), and (2) will stimulate a horde of private class actions against the company (now government owned) for securities fraud. I wish I had a piece of the litigation.
To be sure, Paulson notes his dissatisfaction with a “flawed business model” that creates an “inherent conflict” between the GSEs’ public and private (profit) incentives, and he encourages policy-makers to “reform” the GSEs in accordance with recommendations to come.
But Paulson has put in place a stopgap structure that reforms nothing. He makes a weak effort to claim that the seized companies will “no longer [be] managed with a strategy to maximize common shareholder returns, a strategy which historically encourages risk-taking.” He has it backward; shareholder returns were sacrificed to public-interest goals that justified excessive risk-taking. But, in fact, as he has otherwise admitted, he has punted the entire problem to the next administration.
But an odd punt it is. Why seize and then punt? Again, the clues are in his statement. Paulson worries that the GSEs are so “interwoven into our financial system” that a failure by either of them would “cause great turmoil in our financial markets here at home and around the globe”—there’s that reference to foreign investors again—and be “harmful to economic growth and job creation.”
Ah, there it is. Paulson is worried about the gross domestic product and unemployment numbers going into a highly contested election.
All those who are politically sophisticated know that as GDP goes down and unemployment numbers go up, Barack Obama’s chances to win the presidency go up. On the other hand, if those numbers go in the other directions, John McCain’s chances to win the presidency improve. Paulson wants to minimize financial upheaval in an election year. Also important is an effort to minimize the anger our foreign trading partners may feel if they hold devaluing GSE securities.
Paulson is wrapping bailing wire and duct tape around our economy, hoping the temporary fix will hold until Nov. 5.
And now the big three automobile makers and Lehman Brothers are knocking. They too would like help—before Nov. 4.
Reprinted with permission from Legal Times. © 2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.
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September 16, 2008 | Permalink
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