"In this present crisis, government is not the solution to our problem: government is the problem… It is no coincidence that our present troubles parallel and are proportionate to the intervention and intrusion in our lives that result from unnecessary and excessive growth of government."

Ronald Reagan
Inaugural Address
January 20, 1981

Last week the crisis of confidence in structured assets shook some of the most solid - or at least assumed solid - institutions in the US money markets: Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). While corporate debt markets remain relatively stable, even robust, the once privileged and equally leveraged world of government sponsored entities is under assault, poetic justice to those who've long warned of the consequences of too much debt sitting atop on too little capital in the world of securitization.

Part conduit, part hedge fund, part bond insurer, the GSEs and their nearly $6 trillion in obligations were basically nationalized after last week, yet a private management team and private shareholders still have the power to do great harm to the housing market and to the taxpayer.  To this point, see Bill Poole's letter in The Financial Times this past Friday ("Fannie-Freddie: do US taxpayers want a repeat performance?") where he writes in part:

"The US Treasury secretary is now the ad hoc receiver for Fannie Mae and Freddie Mac. Ordinarily, a receiver's job is to protect a company from its creditors so it can realise maximum value for the creditors as a whole, who are then paid according to the seniority of each creditor's claim. For Fannie and Freddie, the receiver's job is to protect the financial markets, the housing market and the US taxpayer from the firms."

We see the request to Congress by Treasury Secretary Hank Paulson for authority to purchase equity in the enterprises as a prelude to formal nationalization. Any legislation authorizing such an investment must require new governance and management for the GSEs, and also might wipe out existing equity holders. As loss rates on all grades of US residential collateral rise, a formal government takeover of FRE and FNM seems inevitable. So buy the bonds and shoot the equity in the head.

To get a sense for what is likely to happen next with respect to the GSEs, we turn to three experts in the housing finance field: Peter Wallison, Arthur F. Burns Fellow in Financial Policy Studies at American Enterprise Institute; Jerry O'Driscoll, Senior Fellow at the Cato Institute; and Josh Rosner, Managing Director at Graham-Fisher & Co. in New York, who we last interviewed on June 23, 2008 ("Its the Models, Stupid: Interview with Josh Rosner").

The IRA: So who's got something we can like, to paraphrase our friend Larry Kudlow last week. Is there any good news in housing land?

Rosner: I've been calculating how much further home prices need to fall to reach the long-term historic average. We'd need to see average home prices fall to $174,000 from $198,000 today. So, if prices don't overshoot on the downside, the correction is in sight with declines of another 13% or so nationally.

The IRA: Ah, the good news. Is that really going to happen? Retrace to the long term mean and thereby restore affordability?

Rosner: It could.

The IRA: So our many friends and clients in fund land who are making or pondering investments in commercial banks may be a tad early still? We said just that last week to a bunch of eager funds gathered in the wine cellar at Patroon. It's time to start looking, but not buying yet.  Is prowling a good word?

Rosner: Yes. I think so.

O'Driscoll: Not to mention the new investments in FNM and FRE.

The IRA: Does it really make sense to have the GSEs and the commercial banks both in the markets, all looking for equity at the same time from the same investors? The issue of the GSEs can be fixed without raising any capital at all if the Treasury will simply acknowledge reality via nationalization. A 15 minute press conference does the trick.

Rosner: The GSEs are also competing with the banks for cash in terms of sales of real estate taken back from investors or "OREO."

The IRA: Peter, what is your take on the announcement by Paulson regarding the GSEs?

Wallison: Paulson did the right thing at the right time. It was essential for the US government to make clear to the credit markets that it was standing behind FNM and FRE, and he did that. It is absolutely essential for the GSEs to survive and thereby allow our financial system and housing market to survive. That seems to have been accomplished. Paulson threw a lot of stuff against the wall and some of it stuck. We'll find out later what actually becomes law. Now, I happen to believe that the GSEs are going to survive because I believe that the housing market is going to stabilize in the next two or three months. So long as the regulators continue to allow the GSEs to operate and investors believe that the US government will ultimately stand behind the bonds, these enterprises can just go on.

The IRA: But that latter condition in your statement is the key, namely the reliance on the full faith and credit of the US to allow the GSEs to operate and maintain market access. Isn't the idea of private equity capital in a GSE business model ridiculous?

Wallison: Yes. I can't see why the markets would walk away from the GSEs so long as it is ultimately a US government security.

The IRA: But shouldn't we question our collective rationality given your statement? How can we in one breath talk about the need for the US to support the GSEs credit standing, but then talk about raising private equity and the capital requirements enforced by OFHEO? Using private capital to fund a GSE makes no sense. More, subjecting a GSE to a daily popularity contest on CNBC by having listed equity securities seems idiotic to us.

Rosner: Well Peter, first I don't see the real estate markets stabilizing in three months. I see the markets generally down another 10-20% from where we are today. That's how far we need to fall to reach historic equilibrium on an affordability basis. And if you look at the demographic numbers were have declining household formation, which may weaken home demand. The other thing I am very concerned about regarding the GSEs is the fact that the regulator is allowing both FNM and FRE to increase their risk profiles and thereby the moral hazard. Even more disturbing, we're at the point where regulators are turning a blind eye to other accounting shenanigans involving servicing and reporting of loan defaults.

The IRA: So you see the "hedge fund inside" the GSEs getting bigger?

Rosner: Yes. And at this point the GSEs are risking the credit standing of the US government. That should be our primary concern above all. The GSEs have been using preferred debt to raise capital so that these instruments represent about 50% of GSE capitalization. The ratings agencies, who created the concept of an implicit guarantee by the way, previously suggested that going beyond 25% of total capital in preferreds would be grounds for a downgrade, but nothing has happened. If the GSEs are downgraded, then the US may find itself in danger of a downgrade as well. I can see the US standing behind the MBS, but why should the Treasury have to back up one hundred cents on the dollar of the corporate debt of the GSEs, debt which is explicitly not guaranteed and is primarily owned by foreign central banks. The institutions know better and are more than able to shoulder a loss if need be. Remember all the comments from central bankers of the need for investors to analyze the risks of an investment, doesn't that count for them as well?

The IRA: So the GSE hedge funds are financed by foreign central banks? That is funny. And you are suggesting a haircut of the holders of GSE general obligations but not the MBS?

Rosner: Some $900 billion of corporate debt is held by foreign central banks. Until recently, the foreign central banks have historically not bought the MBS but have been buyers of the corporate debt.

The IRA: Jerry, what about you?

O'Driscoll: My argument is that we need to take this as an opportunity to downsize both GSEs. My hope is that if the Treasury does buy shares, that it puts the GSEs into what I call a "virtual conservatorship," where Treasury/OFHEO are actively engaged in management, the dividend on the common is suspended, and we use a combination of forced downsizing and higher capital to get capital ratios to look like a bank. Then privatization is really possible.

The IRA: Sounds like the pure conduit model we described in the last issue of The IRA ("Time for Hank Paulson to Do the Right Thing and Nationalize the GSEs"). We know people in the Valley who could run a mortgage conduit out of their garages - a two-car garage, of course.

O'Driscoll: I'd like to see them downsized to the point where privatization is really possible. The GSEs can't be truly privatized the size they are now.

Wallison: The point that needs to be made is that the idea of a default by the GSEs right now is completely out of the question, whatever the business model is today.

Rosner: But don't you really only need to privatize the MBS portfolio? There really is no reason for the $1.5 trillion portfolio business to exist.

O'Driscoll: Exactly. They need to sell that portfolio over time.

Wallison: Although I strongly favor it, I have to disagree that privatization will be embraced by Congress. The GSEs will be stabilized over time and then Congress will point to the new "world class regulator" and argue that the GSEs ought to be allowed to continue to operate as they always have. What I hope will happen, in this case, is that the regulator will be wise enough to allow the portfolios to run off, and that will reduce their need for funds and capital.

The IRA: Precisely. If you were to scale-back the portfolios to only what could not be sold - essentially the Greenspan Rule - then the capital needs of the GSEs would be modest and the risk profiles very stable. Good for bond investors but not a very compelling equity growth story.

Rosner: Actually the GSEs would make perfect high dividend yield, low-growth cyclical businesses just like a utility. Also, in the currently pending legislation, the regulator would not have the power to require the wind-down of the portfolios.

Wallison: Absolutely agree. Without the retained portfolios that's all they will be is utilities, and for that reason they will eventually want to fully privatize. Utilities don't pay their managements millions.

The IRA: Whether we privatize or nationalize, the objective should be a final solution so that we need not spend any more time thinking about these entities. Wouldn't you agree that getting the GSEs off the front page and into the back office is the real goal?

Rosner: Correct. You can liquidate the portfolios and run off the MBS business over time. But isn't it audacious of Paulson and the Treasury to ask Congress for new investment powers without demanding a change in management? These are two companies that still have massive internal controls weaknesses and don't fully have the systems to operate their business. In testimony yesterday both Paulson and Bernanke said that in performing its consultative role regarding the GSEs, the Fed and Treasury would not take action without consulting with the enterprises!

Wallison: I completely agree.

The IRA: Jerry, what's next now for Paulson? The crisis here is over confidence, not capital, yes?

O'Driscoll: Yes, absolutely the issue is confidence. On Tuesday we had the head of the Fed, Treasury, SEC all coming out to reassure the public. What happened? The dollar went down, the stock markets went down, and the price of the two companies they are offering to back went down. And the second day of a run at IndyMac continued.

Rosner: But aren't these the same officials who came out on Friday and said that there is nothing to be done and no reason to do it?

O'Driscoll: That was another nail in the coffin in terms of their credibility. The question now is whether having the Treasury say that we back these companies is enough. People apparently don't trust the FDIC to back their deposits so it seems fair to ask whether people will trust the Treasury to back these agencies. If we continue with this crisis of confidence for a few more weeks, we'll have effectively diluted the public shareholders to almost nothing when new capital is raised.

The IRA: But isn't that the opportunity? We have to either do a big recap with private equity - hundreds of billions of dollars -- or we nationalize and don't have to raise any money immediately.

O'Driscoll: But this does back to a point already made, namely will the US keep its "AAA" rating if you bring the GSEs back on balance sheet? I didn't even know there were credit default swaps on US Treasury debt until recently. These products indicate that people are worried.

The IRA: But isn't the debt of the GSEs already baked into the overall debt of the US? Don't economists automatically add the GSEs to the overall US debt?

Wallsion: No, not at all. Or, rather, it's like the obligations on Social Security. Try to find it.

Rosner: Let's put it this way. The ratings agencies, especially S&P, have always given the "AAA" to the GSEs based upon the assumed guarantee. But they have apparently never imputed the assumed guarantee of the GSEs in the US government's rating.

The IRA: Well, just as Citigroup (NYSE:C) and Merrill Lynch (NYSE:MER) have been forced to bring their special purpose vehicles back on balance sheet, maybe the Treasury now needs to reaffirm its responsibility for the GSEs. These are, after all, the Treasury's hedge funds, FNM and FRE, correct?

Rosner: Treasury came to the decision about a facility for the GSEs after making some calls regarding the FRE debt issue. Treasury was apparently told by certain Asian central banks that they would not feel comfortable supporting the deal unless the Fed was brought into the picture. The foreign central banks are now dictating US economic policy, this even though they knew that the GSE paper was explicitly not guaranteed.

The IRA: But Treasury and Fed people have always said the opposite in private. Peter, what is your take on this issue of economic independence? Is the Fed in a defensive posture now?

Wallison: Sure, but let me address some of the things that were just said because I do think this stuff is pretty important. Under no circumstances can the GSEs default on their senior debt. If they were to do that, the financial intermediaries and central banks around the world that hold this paper would suffer enormous capital losses. Banks that hold this paper would see their capital decline in value along with the value of the GSE debt. Then we really would begin to see the failure of banks or at least the inability of banks to make new loans. My hope is that we can stabilize the GSEs and see the housing market also stabilize. But if Josh is right about the real estate market declining another 20 points, the GSEs will have to go into receivership. Then the question will be where is the US government going to get the money to ensure that the GSE debt is serviced.

Rosner: But this is precisely why I focused on the use of new debt to expand the portfolios. The GSEs are using the new debt they sell to investors to grow the portfolios and thereby grow their moral hazard risk prior to receivership. Also, there is a big difference between default and some of the other possible options. I view the Paulson proposal as one of laziness and a lack of creativity. There are other options besides outright default. What if we said to the central banks that we are going to give them a 10% haircut on the senior debt, not the MBS. Offer the central banks 90 cents on the dollar of long-date senior debt and 10 cents worth of new preferred. You free up $150 billion in new capital for the enterprises.

The IRA: But Josh, what is the point of raising private equity capital for an entity that must have sovereign backing in order to function? The cost of the private equity or preferred is going to be a multiple of the cost of debt with implicit Treasury backing. Isn't the most efficient way to deal with this crisis to nationalize the GSEs and take that concern off the table for the moment so that we can focus on managing the capital needs of the banking industry?

Rosner: That's why I'm not raising any money for the GSEs. I think we restructure the enterprises via a haircut , not on the MBS, but on the senior corporate debt. This is $150 billion in new and real equity capital.

The IRA: So Jerry, what's your view of this proposal?

O'Driscoll: If we get the GSEs smaller or more stable as a result of raising equity capital, that's fine. More equity makes it easier to privatize in a real sense. And while all of this is going on, you have the investment banks going the way of the dinosaur and Treasury proposing a new vehicle for broker insolvencies.

Rosner: Yes and Treasury is worried about brokers while we are getting ready to see a couple of thousand small and medium size banks sold or closed in the next year or more.

O'Driscoll: If Josh's prediction about the real estate market declining further is correct, then I don't know what we'll do about the banks.

Rosner: For one thing, the Fed needs to act immediately to revise the rules applied to control thresholds for investments in bank holding companies from 9.9% to more like 30%. This will enable private investors to come in and recapitalize the banks.

The IRA: Agreed. We have been hearing from a lot of funds about precisely this issue. This is why we spoke with Ernie Patrikis ("A Change in Bank Control: Interview With Ernest Patrikis") last week regarding the change in bank control rules. Our concern is that finding buyers for failed institutions is going to take time and in the meantime the government could end up owning a large chunk of the banking industry. You notice that there was no buyer announced for all or parts of IndyMac.

Wallison: A lot of what has been said I don't agree with. I think that IndyMac was a special case because of its small deposit base. I'm not sure that changing the Bank Holding Company Act is a good idea, especially taking the level of non-controlling investments up to 30%. The BHCA ought to be completely repealed. What that will do over the long term is reduce the Fed's control over the banking industry, and they are going to be very reluctant to do that. The reason for the restrictions in the BHCA is to make sure that the Fed has control over bank holding companies.

The IRA: I think the key issue here is that funds want to be substantial investors in banks and they want to have representation on the board. But as Ernie Patrikis told us last week, influence is not control. He also supports a repeals of the BHCA. But as a practical matter it seems that the Fed is going to have to be more flexible if it wants to recap the industry.

Wallison: Well, if Josh is right about real estate prices, then the Fed is going to have to open up investments in banks to non-financial firms. We should be getting rid of the BHCA entirely to raise the capital the industry needs.

O'Driscoll: But aren't we headed in the opposite direction? Treasury wants to put broker dealers under some new type of supervision under the Fed.

Wallison: Correct. And by giving special treatment to the investment banks we are creating the same situation which led to the problems at FNM and FRE. We will be very sorry if we go down this road.

The IRA: Precisely. SIPC and the bankruptcy courts do a fine job. We ran a comment in American Banker last week ("Federal Receiver for Broker-Dealers Is a Bad Idea" ) on Secretary Paulson's proposal for a new receiver for broker dealers. Writing it reminded us that in the banking industry, without confidence you've got buptkus. Does not matter how much capital you think you have. In a forced fire sale type liquidation you're lucky to see 50 cents on the dollar of the firm's capital.

Peter: That's right.

O'Driscoll: That's my worry with Josh's proposal. If we do a recap of the GSEs, we may then end up with an RFC type vehicle for banks.

The IRA: So what is the state of play on Capitol Hill? Is it possible to even hope for a proposal as well thought out as the RFC was 80 years ago?

O'Driscoll: No, first of all this could not happen at a worse time because we have a Lame Duck administration. It's an election year and the President's own party is not inclined to support any bold proposals. No, I think that this is going to slide into the next administration. But you are going to have the problem Josh has been raising, which is that these guys at the GSEs are expanding their moral hazard even while we fund them in the interim.

Wallison: Josh is completely right about what will be going on at FNM and FRE while they are being supported by the capital markets and by their regulators, who will be saying that the GSEs are not insolvent. It is correct that the GSEs will be taking on new risks. But the alternative is worse.

Rosner: But that is where I disagree with you, Peter. If you are talking about defaulting, then we are in agreement. But as we discussed earlier regarding the banks' capital needs, there are different types of bankruptcy. You could present a restructuring package to the holders of the senior debt, again, not the MBS, and present a pre-pack, which is a haircut as opposed to a default.

Wallison: I just don't think that it is realistic to talk about a haircut.

The IRA: The constituency we are talking about here is not very flexible…

Wallison: All of the holders of GSE debt would see their capital decreased across the board and it would literally kill the dollar if central banks around the world have to take a haircut. Confidence in the US government's credit would collapse.

The IRA: I don't think that global commercial and central banks would appreciate the nuance of your proposal, Josh.

O'Driscoll: Foreign investors would then see the Treasury's own obligations as being untrustworthy. They would dump Treasuries and the dollar would crater.

The IRA: Look, we've lost two primary dealers in the past six months. We came very close to cratering the Treasury market with the Bear failure. It seems as though we are experiencing waves of erosion in confidence that are working their way up the food chain to the highest quality obligations such a Treasury debt.

Wallison: I don't know about Treasuries, but there certainly seems to be a crisis of confidence in the various classes of asset-backed securities.

Rosner: I think a lot of the fear results from a lack of confidence that anyone is at the helm in Washington.

O'Driscoll: That's what I was alluding to earlier.

Wallison: Yes, I am very disappointed in Paulson.

The IRA: It is astounding, isn't it? We thought that Paulson was a master of the universe. Looking at the carnage in the housing and banking sectors, and the stories we're hearing from the public sector. Is there a potential for this financial crisis to become the issue in the November election? We have this nightmare image of the FDIC closing several banks at once just days before voters go to the polls. Who do voters pick when the economy is in a meltdown?

Wallison: If Josh is right about the direction of housing and it goes down another 20%, yes there will be a huge crisis in the banking industry and at FNM and FRE, and the US government will be heavily involved. It has to be.

Rosner: Peter, what if we look at the housing problem differently, namely in terms of demographics and especially generally stagnant real wages relative to home prices over the past 40 years. If we were able to figure out a way to re-engineer US competitiveness, then we could deal with the affordability questions with higher incomes.

Wallison: Sure, it would be nice, but we've never figured out a way to do that and we can't do it before the housing crisis is upon us.

Rosner: I think we should let FNM CEO Dan Mudd and FRE CEO Richard Syron run the US Treasury.

O'Driscoll: Again, my hope is that this crisis will serve as a catalyst for down-sizing both enterprises. To me, that is a positive outcome from this situation. It lessens the amount of capital that needs to be raised.

The IRA: Agreed. How bad are the latest accounting games?

Rosner: I think that the US government should not be allowing the servicing games that both GSEs are playing which I believe manufacture the appearance of solvency. I think that since the authority exists now, the government should immediately put both enterprises into a conservatorship to limit such behavior. I still think it is possible to restructure the enterprises in such a way as to save the MBS holders and put a small haircut on the holders of the senior debt, a haircut that could easily turn into a gain.

The IRA: But does the current receivership give the Treasury the power to restructure the entity in the same way as the FDIC does with a bank?

Rosner: No, but it lets you get rid of the current management.

Wallison: The new legislation gives the government the power to restructure a la the FDIC. But if you take over one or both GSEs, you have to make sure that you have the cash to meet their obligations.

Rosner: That's why I like creative solutions. For example, if Congress provided OFHEO a credit line from Treasury to use to maintain cash flows to MBS holders while the retained portfolios were liquidated, that might provide a mechanism to manage the restructuring of the GSEs without adversely affecting the capital markets. If Treasury were to consider the pre-pack idea I have suggested, we could restructure the enterprises with little cost to the taxpayer.

Wallison: You and I just disagree on the implications of a haircut for senior bond holders. Where we agree is on giving the receiver of the GSEs the power to borrow from the Treasury to meet cash needs and therefore run the process in an orderly fashion. I have been advocating such a credit facility for months. The only question is whether the receiver will have direct access to the credit line that Paulson is calling for, and I believe the answer to that question is yes.

Rosner: I am much more comfortable with the receiver having access to the funds than providing access to the management of the GSEs.

Wallison: Correct. If the Treasury advances any money to these enterprises, then we must take them over. We cannot allow the GSEs to be operated as they have been once the US government is actually involved.

O'Driscoll: That is my virtual conservatorship model, whether they have been placed formally into a receivership or not.

Rosner: The fact of receivership also creates a very beneficial incentive to both enterprises to do the right thing so that they can emerge from government control. Current management will do anything they can, including diluting current equity holders down to nothing, in order to maintain control of their respective companies and avoid the government taking control.

Wallison: That is true, but I am not sure that the incentives work the way you hope. What we saw with the S&Ls was that they gambled with no capital at all in order to try and achieve resurrection. But as I said before, were any funds to be advanced by Treasury, then the government would become the new equity holder and appoint a new board of directors and management team.

Rosner: But why should the government want to buy equity in a GSE? Makes no sense.

Wallison: I think Paulson was trying to communicate to the global capital markets that the US would stand behind the GSEs. Buying equity in the enterprises does not make a lot of sense. But the really wacky idea is the notion of the GSEs borrowing from the Fed's discount window when they can borrow at Treasury rates in the markets.

The IRA: As much as I'd like to see Josh's pre-pack plan given a chance to work, it is really hard to see global central banks agreeing to such a scheme.

Rosner: Then we are probably going to see the result nobody wants, namely the junk status of the GSEs eventually transferred to the US government itself and a potential credit ratings downgrade of the US.

O'Driscoll: A question I have for Peter is this: If the enterprises are taken over, don't they lose status as being issuers of bank eligible paper? Does not a receivership basically throw the entire mess into the arms of the Treasury?

Wallison: Yes it does. That is why we need to be very careful to avoid a default by the GSEs. I think this is part of the reason that Treasury bought onto the idea of giving the Fed a role in this process.

Rosner: I am more worried about the idea of the Fed being given some new consultative role vis-à-vis the GSEs than anything else. The Fed is the safety and soundness regulator that has failed us worst in this crisis. In terms of the leverage ratio, in terms of the allowance of changes in what constitutes bank capital, in terms of the Fed's prudential oversight of their institutions, I find it very worrisome.

Wallison: I agree with you.

O'Driscoll: That is the point of Alan Meltzer's piece today (July 16, 2008) in the Wall Street Journal, "Keep the Fed Away From Investment Banks," that the Fed's track record as a regulator is appalling.

Wallison: They do have an appalling record. But for some reason they maintain the support of the Congress, which is unwilling to take away their regulatory role.

O'Driscoll: The Fed can print an infinite amount of money, so the political reaction is understandable.

Wallison: We've got a lot of problems to wrestle with at one time.

The IRA: We'll leave it there. Thanks

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