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Paulson Begins Gradual Wind-Down of GSEs within Conservatorship
September 8, 2008

Paulson Begins Gradual Wind-Down of GSEs within Conservatorship

"Prior to the announcement I was worried that [the Treasury] would maintain the status quo and continue to throw money at [the GSEs]… Now it appears they are fundamentally changing them, which is good. These companies are now in the process of going away. They even threw in the FHLB (via a secured lending facility) which is also a positive step as they need to go too. The first step is nationalization. Eventually they should sell them off as 10 different private companies with no more ties to the U.S. government. This is going to cost the Treasury A LOT of money, but is necessary to get them out of the mortgage market. Fannie was necessary in 1938 but not in 2008. It is going to strain the Treasuries' finances. It can also mean much higher Treasury interest rates, offsetting any narrowing of mortgage spreads."

Jim Bianco
Bianco Research
September 8, 2008

We congratulate Treasury Secretary Hank Paulson for finally acting on the advice of many in the market, including The IRA, and imposing a conservatorship on Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). Moving a week after Labor Day is not bad timing at all and now enables us to focus on the next task, namely providing the financial resources to backstop the FDIC (see our earlier comment, "Memo to the President-Elect; How Much Capital Does a Bank Need?', August 21, 2008").

Call Paulson's announcement a good but still half step in the right direction. Thoughts:

The Treasury has sought to reassure the debt markets, but has done so in a way that tries to maintain the fiction of private ownership of FNM and FRE. In so doing, Secretary Paulson only draws greater and greater attention to the contradictions and strains inside both GSEs. Indeed, the statement from OFHEO explicitly draws attention to the conflicted business models of both FNM and FRE:

"The Boards of both companies consented yesterday to the conservatorship. I appreciate the cooperation we have received from the boards and the management of both Enterprises. These individuals did not create the inherent conflict and flawed business model embedded in the Enterprises' structure."

We understand from news reports that the boards of directors of both GSEs have told OFHEO and the Treasury that they will only take down $1 billion in new preferred, this because neither entity has an immediate cash need and the boards are reluctant to dilute existing holders of both the common and preferred. But this situation only illustrates the half-way nature of the Treasury plan and the untenable position facing FRE and FNM directors.

Under delaware law, corporate directors have a duty of care to the corporation they serve - not to shareholders. Why each and every director of FNM and FRE with any common sense does not resign immediately is a wonder to us.  OFHEO may not blame the directors of FNM and FRE for the "inherent conflict and flawed business model embedded in the Enterprises' structure," but civil plaintiffs certainly will. 

Once the Treasury and OFHEO announced the conservatorship, the control of the two federally charted corporations clearly was taken away from the public shareholders and the corporate directors.  With the government making wholesale changes in management and apparently taking operational control of both enterprises, how can any director of FRE or FNM be comfortable continuing to serve?  We can't wait to see the 8-K that is eventually filed with the SEC by FNM and FRE explaining the Treasury takeover. The public disclosure of both companies is becoming more surreal with each passing day.  Again, given the relevant provisions of Sarbanes-Oxley, how can any director of FRE and FNM be comfortable continuing to serve?

Going back to the platypus metaphor that we and others have applied to the GSEs, the fact that these government sponsored entities are still traded on the NYSE and are subject to SEC registration has and will continue to complicate life greatly.  As we understand the Treasury proposal, Paulson will use general public funds to purchase preferred debt in the GSEs that carry a 10% dividend as well as warrants.  The Treasury's strategy is apparently intended to provide a buffer between the GSE common and preferred shares (which presumably will be left worthless if the Treasury purchases the full $100 billion authorized, but not officially wiped out) and the unsecured, corporate debt of both GSEs, which is used to fund the retained portfolios of both enterprises.

Of course, were the common and preferred equity of the GSEs to be exhausted, losses would then fall upon the unsecured debt holders - thus the Treasury approach makes a certain amount of sense in terms of protecting all bond holders and holding out the hope - slim as it may be - that the Treasury can eventually sell its controlling stake in the GSEs for a profit.  That's apparently why the Treasury has told the NYSE that FRE and FNM will continue to trade, but we hope that the NYSE eventually summons the courage to delist both firms.  The new concerns about accounting irregularities alone should give the NYSE pause in allowing these heavily damaged issuers to remain listed. 

Thankfully, OFHEO and Treasury seems to have embraced our view that the retained portfolios must be reduced over time to just $250 billion for both GSEs combined. This is about the right size to support the conduit operations in the secondary markets but leave the portfolios so small that they no longer constitute a systemic risk.  However, we continue to believe that an outright nationalization is the most rational path for Washington to pursue, probably after the November election is decided. Once losses at the GSEs reach a certain level, buying more and more preferred shares is going to become an increasingly futile and painful exercise as common and preferred shareholders of the GSEs are slowly consumed.  Then the Congress will be forced to act to re-nationalize both GSEs and put the public holders out of our misery.

The "inherent conflict and flawed business model" referred to by OFHEO is gradually making the US the laughing stock of the industrialized world. But since the source of the conflict within the GSEs ultimately stems from political corruption in Washington, corruption which is embedded within national housing policy and which the Big Media refuses to acknowledge much less pursue, fixing the problem may take an even deeper and more serious financial crisis than the one now generally expected.

But all things considered, Secretary Paulson's actions deserve our support.  We put out the following statement on Saturday:

"Reports of the impending takeover of the GSEs by the Treasury and the creation of a conservatorship to [manage] the $6 trillion in direct and indirect commitments made by these two entities is great news for the markets and the taxpayer. Contrary to some news reports, the conservatorship should not result in a large immediate need to raise cash for either entity. Indeed, the sharp decrease in borrowing costs that will likely occur next week will provide immediate and continuing relief to both Fannie and Freddie. While the GSEs may require some public subsidy in the medium term to help meet guarantee commitments, particularly if loan loss rates in the US continue to mount above levels seen in the early 1990s, the good news is that a scaled down GSE operation that sheds the retained portfolios, prices guarantees realistically and focuses on the historic role of secondary market maker for US mortgage lenders actually will generate stable profits for taxpayers. If the GSEs are run like a utility, and not a hedge fund, then they can be a stable and entirely unremarkable part of the financial scene. The impending conservatorship is hopefully a way to make the former business model a reality."

Now that the Treasury at least partly has followed our recommendation and taken the GSEs off the table as a concern for the bond investors who hold trillions of dollars worth of GSE debt, the markets and the respective presidential candidates can focus on the next, more pressing challenge, namely helping to refloat the US banking system. Our indicators for lender stress in the US banking industry as of Q2 2008 are already above early 1990s levels, thus the timely action on the GSEs by the Treasury allows Washington, regardless of who wins in November, to now focus on how to put in place the resources necessary to triage unsound banks and help sound institutions begin to make loans and securitize these assets for investors.

Hopefully Paulson and his peers in the US regulatory community are already working on this next, much larger piece of the puzzle.  Again, we believe that by Election Day the Congress needs to have authorized up to $500 billion in new borrowing authority for the FDIC and the creation of an "RTC II" vehicle to carry and sell failed banks and assets.  Only when we fix the commercial banks and enable them again to make new loans into the primary market for credit will the secondary market role of the GSEs again become relevant to a reviving US economy.

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