Secretary Paulson’s Endgame for Fannie and Freddie

My Fannie Mae (FNM) and Freddie Mac (FRE) preferreds were listening today to: “Remarks by Treasury Secretary Henry M. Paulson, Jr. on The Role of the GSEs in Supporting the Housing Recovery before the Economic Club of Washington”. I cannot say for sure that some doubled from their sub-dollar base due to Paulson, but much of the Paulson team and financial rescue infrastructure will remain with the new President Obama Administration.

My guess is that Geithner will follow Paulson’s lead when he inherits the Treasury Secretary post, despite Summers and Bernanke’s lack of discipline on fiscal and monetary expansion. Let the floodgates open. But, remember Paulson is always looking for ROI, even though at times his plans appear to be schizophrenic. While Obama, Summers and Bernanke appear to be soul brothers in “better to over stimulate than not enough”, they appear confused in how to structure long-term benefits. This leaves an opening for Paulson via Geithner to direct the evolution of Fannie and Freddie out of conservatorship.

Paulson gave us additional insight into why he structured the GSE rescues as conservatorships. He purposely did not ask Congress for an explicit government guarantee of Fannie and Freddie debt and MBS because he did not want to lose the discipline of private sector credit evaluation. At the same time he did not believe the private sector had the capacity to guarantee the totality of the mortgage market, citing the difficulties encountered by the monolines (ABK and MBI). All this was of course academic when no one was willing to buy GSE securities without some type of government guarantee. But, Paulson was actually planning the exit strategy from the start.

Paulson sees support for the mortgage market as a public-private partnership with the amount of public support to keep mortgage rates low to be determined by the Obama Administration. His vision is that the GSEs will not incur the interest rate risk of holding a portfolio of mortgages. They would be limited to warehousing mortgages in preparation for securitizations. The GSEs' primary function would be to insure credit risk. Limiting credit risk is key to keeping mortgage interest rates low.

Paulson appears to favor one of two models. The first would only partially guarantee MBS credit risk, forcing the private sector to still evaluate credit risk. The second would turn the GSEs into heavily regulated utilities with 100% government guarantee against credit risk. Though Paulson liberally uses the word replace, he never states the preferred shares will not be carried into the new enterprises.

While Paulson clearly wants to wind down the GSEs’ profits and risks in maintaining large mortgage portfolios, he states that the government is profiting immensely from the spread between GSE backed MBS and treasuries. Unstated is the risk the government is incurring by borrowing short and lending long. Given enough leverage, the government could drive mortgage rates down to 4% and make a huge profit. This is Paulson dreaming because he then states that the amount of Treasury borrowing to accomplish this would be astronomical. I don’t know if Bernanke read the second part. But even if Bernanke did, he would not be afraid of large numbers.

I believe Fannie and Freddie will eventually become low profit utilities, guaranteeing less than 100% of the mortgage credit risk. Under either of Paulson’s recommended structures, the GSEs would pay the government for reinsurance. As utilities, the GSEs’ preferreds become more secure and therefore more valuable. Thank you, Secretary Paulson.

Final note: Paulson declared the GSEs' failure would set off a systemically overwhelming disaster in the derivatives market. Since when is it the government’s job to prevent moral hazard from CDS counterparty risk? Likewise, government would not let American International Group’s (AIG) counterparties suffer.

Disclosure: Author is long ABK, AIG, FNM, FRE and MBI.

Comments

[Crocodilian:]

"He purposely did not ask Congress for an explicit government guarantee of Fannie and Freddie debt and MBS because he did not want to lose the discipline of private sector credit evaluation."

Ummm. That's not such a convincing argument, given the feeble performance of "private sector credit evaluation".

How about this alternative explanation:
Making the guarantee explicit would have required the Government to put the guarantees on _its_ balance sheet.

As to your thesis on the GSE preferreds, we're now in the domain of "political investing", where the numbers and the business logic don't matter, and financial outcomes are decided politically.

The GSE Preferreds are thus like the old Tsarist bonds . . . you had to make a judgment about whether a Russian government would ever decide to pay them off. . . a lot of money can be made that way, but its political speculation, not investing.

Jan 08 03:31 PM