Fannie, Freddie: What Paulson Learned From the Pentagon

When smart generals develop a war plan, they try to anticipate every possible scenario. But they don't hold a press conference to announce the details—mostly they keep everything secret. They may even leak a deceptive nugget or two to throw the enemy off-track.

Treasury Secretary Henry Paulson isn't exactly waging war with Fannie Mae (FNM) and Freddie Mac (FRE), or with the bond markets. But it's certainly a high-stakes standoff. Paulson wants big investors to bail out the two struggling mortgage giants by continuing to buy their bonds and equity shares. But to keep investors from bailing themselves, Paulson has pledged that, as a last resort, the government will inject money into Fannie and Freddie if that's what it takes to keep them in the mortgage business. And that's about all he has said.

Some critics have questioned the vagueness of Paulson's plan or ridiculed Treasury denials that a bailout is imminent. There's understandable frustration about the lack of detail involving two institutions critical to the U.S. housing market. But an optimistic observer might also conclude that Paulson's has demonstrated some shrewd maneuvers borrowed from the annals of grand strategy. Some of his tactics:

Psychological operations. In military jargon, a PsyOp is a glorified propaganda campaign meant to persuade a group of people to behave in a way favorable to the party mounting the PsyOp. And what else is Paulson doing if not trying to win over the hearts and minds of investors? The last thing the Bush administration wants is a huge bailout of yet another foundering financial firm. So, even if one or both firms is technically insolvent, Paulson has assured the financial markets that Fannie and Freddie will remain capitalized and keep functioning. So keep buying those bonds. There's no trouble here.

Feints. If you're planning to flank your enemy on the left, you want him to think you're coming on the right. Paulson and his deputies probably know some kind of bailout is likely. But if they broadcast that, what will Fannie and Freddie do? Behave as if they don't have to answer to shareholders, who could get wiped out if there's a bailout. OK—maybe F&F have already behaved that way. But if a bailout were a sure thing, investors would maneuver to take maximum advantage of it, just as if you announced the starting date and exact location of a military campaign. So Paulson et al continue to demur on a bailout while quietly preparing their forces for action.

Strategic ambiguity. What will a bailout look like? Best to keep everybody guessing. Telegraph one plan or another, and investors will trip over each other racing for the exits or maneuvering for optimal position. And Treasury could lose the initiative and give up leverage over Fannie and Freddie. But if Treasury surprises everybody with the timing or scope or type of bailout, that's the best way to get ahead of market forces and assure that nobody gains or loses unfairly. It would also help pre-empt charges that Paulson tipped off Wall Street cronies or favored politicos who might stand to gain from a bailout.

Overwhelming force. As the Pentagon has learned the hard way, successful campaigns require decisive action—not incrementalism. That's where Paulson's "blank check" comes in. By securing unlimited funds and authority to intervene with the two quasi public institutions—a key provision of the housing law passed in July—Paulson has armed himself with a powerful arsenal. He can mount a thorough rescue plan—including long-term provisions for either preserving the two companies as they are, or carving them up into something else—without having to get congressional approval every step of the way. This would allow Paulson to operate like a field commander authorized to do whatever battlefield conditions require, without having to answer to politicians and interest groups. That will let a bailout plan succeed or fail on the merits and execution. If there is a bailout, that is.

Comments

[edpal63:]

I am 100% cash at the moment, the markets are going down pretty bad, Shark, I hope you are wrong but only god knows!

2008 Aug 24 05:29 AM

[investor88:]

Rick rightly concluded his gloomy [gloomy because we are not discussing euphoria like commodity prices rising enriching traders/investors but the article discusses possible funeral arrangements for FF which means people suffer other than daring shorts!] article with "if there is a bailout plan that is". Remember Warren Buffet who said you only know who swims naked when the tide is out?

Shark and Edpal make very sensible comments which I tend to agree with. Both make the point that the only safe haven now whilst the "house is burning" is holding cash, 100% cash. Edpal says of Shark's fears that only God knows. The average investor/trader might find it not worthwhile to test the severity of the storm, never mind that Warren Buffet says that since 1776 it has not paid to short America and it is not about time in 2008 to short America now. Warren never invested through the last Depression of the 1930s, that is not to say the world led by America is going into one now. Caveat Emptor, fair?

2008 Aug 24 05:48 AM

[notsosmart:]

how do you know if cash is good? you cant eat it.

2008 Aug 24 10:48 AM

[rsen01:]

"There's nothing cheaper than free advice...and nothing easier than spending someone else's money." The only question is how much the taxpayers will pay to support an egregious policy to "privatize profits and socialize losses." Nauseating stuff.

2008 Aug 24 11:41 AM

[David Martin:]

So, 1776 to 2008 where it hasn't paid to short America.
Lets hope that the bear market does not last as long.

2008 Aug 24 12:32 PM

[gurby:]

I dread to here the phrase 'Taxpayers losing' as if it will affect them directly and as if they owe the tax paid. In reality the whole plan is to sucker investors at the expense of frivolous taxpayers who evade and over consume beyond their savings buying houses, TVs, cars, and everything they cannot afford.

Politics aside, and inspite of what Alan Greenspan and Warren Buffett have said, the initial FED's fannie and freddie bailout plan is indeed to essentially safeguard taxpayers and private equity(gamblers and greedy individuals) rather then genuine long term investors. Those who say it is sell out do not understand the real maths. Taxpayers stand to loose much much more if Freddie and Fannie are nationalize and not to mention the cascading fallout to mortgage/insurance markets and the trust people have in the administration to honor its GSE institutions. The markets(genuine investors) know this and therefore want more assurances from the govt that they will let the markets find the equilibrium rather then nationalize and leave investors with nothing. If the markets do not participant, the taxpayers stand to loose big time as GSE loans are clearly sovereign loans. The govt will have to come out with much more and with no assurance of getting back anything in return.

The other alternative of selling out to private equity with zero value to current investors will also be a fatal error. They will strip the companies take their profits and sell it. The markets and global investers will also loose faith in all the assurances the govt and Freddie and Fannie have given to invest more in these companies just a few weeks ago. The
trust once lost will take a long time to gain back. There is also no gaurantee that private equities have national or broader social concerns. Their priority is going to be their own stockholders, who essentially are again the markets.

The market is looking for firm and decisive actions to show that the govt is prepared to invest in Freddie and Fannie in the short term to shore confidence against the poor negative sentiments. Freddie and Fannie are not yet bankrupt and their business models are still relevant albeit in certain rough patches. with some short term help They have enough cash returns and expenses to roll over and navigate from the current crisis.

Time is of essence. The FED need to act fast and decisively.

2008 Aug 24 12:36 PM

[msgtb:]

It is sad to say but an 84 year old retire has a better plan that the setting Fed Chairman Bernake! Write your congressman and senator and tell them you want to go with the Greenspan plan.

2008 Aug 24 01:27 PM

[nova:]

The good news: both Treasury Secretary Henry Paulson and his FED friend Chairman Bernanke will be out off job very shortly regardless of who will be the new President.

However, American people will be too busy fighting poverty.

2008 Aug 24 04:27 PM