Paulson Tops Gross, Greenspan and Ackman in the Mortgage Battle

The most powerful man in Washington, Treasury Secretary Hank Paulson has shown himself to be quite a shrewd politician. The prevailing wisdom is that he accepted the $300B FHA housing bill so that he could create the Fannie Mae (FNM), Freddie Mac (FRE) and Federal Home Loan Bank [FHLB] backstop. The much talked about unlimited power of the Treasury to lend and buy equity, which will never be needed. I disagree. I believe that Paulson created the heightened GSE anxiety for the express purpose of passing the Frank-Dodd FHA mortgage-refinancing bill.

Paulson’s high-wire balancing act involved appeasing the Administration’s need for moral hazard by feeding the Republicans Bear Stearns (JPM), and then feeding the Democrats the GSE backstop to tack onto their FHA bill. A setup that made the FHA bill veto proof. President Bush showed his distain by signing the bill privately. From Paulson’s and Bernanke’s perspective, it is the FHA component that will provide the most benefit to the banking system. Paulson’s pragmatism triumphed in a tough political environment.

This giant combo bill brings difficulty to PIMCO’s Bill Gross and Pershing Square’s William Ackman. Both of them are betting that the GSEs will be nationalized by the Treasury, and have used the backstop to plead their case. Nationalization would benefit Gross by increasing the value of GSE notes and bonds, and Ackman by making the shares he is shorting worthless. Both are pressuring the Treasury to buy GSE equity in the name of expanding GSE support for the mortgage market.

Gross has engaged Alan Greenspan to plead his case in public. Several Wall Street analysts are also preaching the dire consequences of a reduced GSE role in the mortgage market. They cry that without a Treasury takeover, no one is out there to pick up the reduced GSE demand for mortgages. Therefore, it is unconscionable for the GSEs to strengthen their balance sheets by reducing their portfolios.

It's too bad for Gross and Ackman, as Paulson has another point of view. Fannie and Freddie can reduce their portfolios and the FHA will pick up the slack. What Gross and Ackman lost sight of is that many banks own GSE equity (mostly preferred) and the failure of GSE equity would reduce banks’ capital adequacy. Paulson and Bernanke don’t want that to happen.

Disclosure: The author is long FNM, FRE and JPM.

Comments

[madasiwannabe:]

I think the assumptions in this article are wrong. Both Ackman and Gross stand to make billions at the demise of the GSE's. As the GSE's slip, so does their security ratings, and up goes the rate of return to attract investors. Brokers such as PIMCO will make higher rates of return and as the GSE's fall, so will the short sellers.

The housing bill has done nothing but enable a zero risk, taxpayer backed assult on the GSE's. If the GSE's are taken over, the Fed will have to assume the debt. A $5 trillion dollar, high risk portfolio added to strained US instruments will most likely cause all US backed securities to fall to junk status and make companies like PIMCO enormously rich.

If the Fed infuses capital into the GSE's people like Ackman will simply bleed it back out. It sounds to me like we the taxpayers are caught between a rock and a hard place. Thank you Alan Greenspan. You are smarter than we thought.

2008 Aug 11 11:03 AM

[CaptBob:]

It's Bankers helping Bankers--in the guise of public housing salvation.
Or Banker wolves in John Q's clothing.

What is really beautiful about this is it moves private enterprise under the Federal umbrella, while appeasing the Privateers by allowing them to squirrel away any "tranches" of value for private profit, while Socializing all the toilet paper of no status but "Debt" to be later paid for by the taxpayer.

I saw this one coming, to the letter, at the first Freddie and Foolee whimper!.

2008 Aug 11 01:08 PM

[Curious Spe...:]

Please kindly explain HOW "people like Ackman will simply bleed it back out"? And how did Ackman and others managed to make huge profits by shorting FNM and FRE in the first place? Why did the big banks and funds that own FNM/FRE equity stand aside and let it happen? What is the mechanics involved?

2008 Aug 11 02:29 PM

[madasiwannabe:]

As we all know, the housing bill authorized the government to buy stocks and infuse capital as necessary to shore up the GSE's. If the Fed buys stocks to shore up the GSE's, how will those stocks hold that value if there is a constant downward pressure due to growing loss of confidence? The purchase may push stocks up, but inevitably that value would fall(shorts would pull the value back out). Any infusion of capital will ultimately be offset by the loss of income from the downgrades in the GSE's securities (Brokers will make higher profits on "high risk" government backed securities). The question is not why would the banks let it happen; the question is how would the banks be able to stop it? Their money would go to the same place as the governments.

Today S&P downgraded the preferred stocks and some of Freddies securities. Freddie also reported they had trouble attracting buyers to today's $2 billion securities auction. This will cut into the GSE's ability to generate income and therefore accelerate their decline. This is a death spiral and without a major course change, I believe the US taxpayers will have to pay for it, directly and indirectly.

There are only 2 winners in this game.... Securities brokers like PIMCO and hedge funds like Persing Square (using them because they are referenced in this article). The only way for the taxpayer's to win is to change the rules of the game. The only way I can see is for investors to jump in and shore up the GSE's. As the stock gains strength, the GSE's will recover and be able to clean their portfolio's and absorb their own debt.

2008 Aug 11 06:25 PM

[elwind45:]

The banks are going to raise capital to support the GSE's? The article gives ole HANK way to much credit! Why would any investor risk capital to help the GSE's, while housing prices are still falling? The FHA is being used to lengthen the ponzi scheme. Granted Paulson put the fear into the congress, by explaining the massive FHA liabilities! However giving FHA 300B and only giving the mac's 25B, shows that Paulson thinks there is value to be gained from the Mac's. Dubai gets Park place and boardwalk, Paulson gets a get out of jail free card and the taxpayer gets stuck in the community chest.

2008 Aug 12 01:54 AM

[madasiwannabe:]

The more I thought about this article, the more I think we are not giving paulson enough credit. If FHA refi's 300B of the GSE's high risk portfolio, it would pull the heat off and the GSE's could start to recover. There's no direct capital investment in the GSE's and no value added to the share holders. Why do you think they are the GSE's putting incentives out there to get these mortgages converted? Most of the new mortgages last month were refi's so it sounds like it's already working. Question now is will the refi's end up defaulting. If they do, FHA might need a bailout, but I feel better knowing the bottom feeders in this article won't get fat on my tax dollars.

2008 Aug 12 05:39 AM

[jeclare:]

I am curious to know how much of the GSE's equity is actually owned by US banks? How did you go about determining "that many banks own GSE equity (mostly preferred) "?

Do the GSE's identify the holders of their preferred? Did you examine the balance sheets of "many banks" to determine the nature of their holdings? Is this information publicly available?

2008 Aug 12 12:43 PM