Problematic GSE Bailout

After taking months to consider alternatives for the GSEs [Fannie Mae (FNM) and Freddie Mac (FRE)], the US Treasury has decided to go forward with a forced recapitalization of the companies. According to leaked press reports, equity investors will suffer near total dilution and debt will be government guaranteed. Such a plan has negative implications for the US capital markets over the long term. Here they are in a nutshell:

Bailing out bond holders is the worst type of moral hazard

Government intervention in Bear Stearns (BSC), at taxpayer risk, quietly created a windfall for Bear Stearns bond owners. A bailout of GSE debts will enrich bondholders to the tune of hundreds of billions of dollars.

What kind of message does that send? While so many are quick to criticize common shareholders, who were effectively wiped out before this bailout, debtholders are not being called to task for their failings. Debt investors are meant to police balance sheets and constrain management. If GSE debtholders relied upon a perceived government guaranty, and didn’t analyze the balance sheet, they haven’t done their job.

Ask yourself, would the GSEs be such a risk to the financial system if debtholders had questioned their credit status in 2005 or 2006? The problem with Bear Stearns and the GSEs wasn’t that their shareholders wanted them to have too much leverage - equity investors are supposed to want leverage and eye popping returns. The failure in the system was that debt investors gave them money too cheaply, allowing them to reach high levels of leverage. Bailing out debt investors encourages these problems going forward.

Ignoring regulatory capital has risks

To suddenly put the GSEs into conservatorship because of capital inadequacy seems difficult to swallow in light of their stated capital requirements. Of course, the GSEs' regulatory capital was a poor representation of economic capital, but that was true 3 months ago. It also was true when Fannie raised equity not that long ago.

In fact, regulatory capital is not reflective of economic capital for the majority of US banking institutions. If the GSEs can suddenly be facing new capital calculations, what financial institutions are to be considered adequately capitalized. If Lehman (LEH) gets in trouble, will the SEC be encouraged to take a closer look at their capital calculations, will the Fed shut off access to the discount window? And what about banks where a mark to market on their loan book would show massive losses - is the FDIC going to use some new standards to decide when to step in and shut them down? Or will banks books get more scrutiny only when their share prices are low and the market chatter is high?

Capital rules should be applied consistently, not on an ad-hoc basis.

Verbally abusing equity investors is counterproductive

All of this chatter about punishing shareholders is sending the wrong message. Equity investors know they can lose their money if a company goes bankrupt due to a liquidity crisis. As long as the laws are followed as written, equity investors can assume those risks. If the GSEs have their equity wiped out before a liquidity crisis and while meeting statutory capital, that creates a very uncertain legal environment for equity investors at a time when the banking system needs to raise lots of equity capital. After Bear Stearns and the GSEs, why should investors look at buying equity in distressed financial institutions?

At the time of writing, we don’t yet have the details of the Treasury’s plan. As the details come forward, hopefully there will be more discussion as to how to address these problems going forward.

Disclosure: none

Comments

[venividivici:]

In August last year it was apparent that this financial market did not have a shred of credibility and that revelation is being reinforced time and time again. Where will all of this end? Well if it is not in a catastrophic disaster, the world can count itself very lucky.

2008 Sep 07 09:14 AM

[madasiwannabe:]

Even the most casual observer can see a government takeover is total BS. A lot of people are going to make a lot of money next week at the expense of the taxpayers, and as you pointed out, it's not just the shorts.

So the government takes over the GSE's. What does that really do? If I can't pay my bills, changing accountants won't make me suddenly solvent.

What is going to happen to the governments credit rating now that they have just added $5 Trillion to the already $12 Trillion the national debt? 8 years ago it was $4.3 Trillion. What about the dollar? We have nothing left of value to hock and what we do have is losing value. Do we really think the interest rates will go down for more than a few weeks because of a takeover? When the GSE shark frenzie is over and irrational exuberance subsides, the reality we are still bankrupt will set in and we will start the downward spiral towards the biggest crash ever seen in history.

2008 Sep 07 09:35 AM

[otbricki:]

As far as I can tell this move is triggered by exactly the lack of confidence by the bond markets that the author of the article is advancing as a good thing. It is mostly a emotional reaction at a fairly late stage in a financial upheaval. The actual cost it taxpayers is not "hundreds of billions of dollars". Freddie and Fannie are losing about 1 billion per month between them, far less than say the big three automakers who are next up for a bailout.

This is a smart move because of the fear in the market, and the connectivity that the Freddie and Fannie have with other important money flows. The cost to the taxpayer is far outweighed by the impact that this takeover will have.

While it may not put an end to the problems in the current economy, it does put an end to the doomsday scenario and the possibility of another Great Depression.

2008 Sep 07 09:42 AM

[prescient11:]

Gross and Greenspan talk their book and make a ton of money. The game continues. I agree, debt holders should f'ing suffer too, they were just as bad as this author points out.

Excellent point.

2008 Sep 07 09:58 AM

[captainccs:]

I really don't see the logic or fairness of protecting one class of investors while wiping out another class. The message is: "Don't ever buy shares of financial institutions, specially if they are close to the government."

If you were to let the game play out, the shareholders might, indeed, get wiped out but the bond holders would also suffer massive losses and that's the way it should be. By intervening, the Treasury is giving way too much protection to the bond holders.

It is interesting to note that in the case of Bear Stearns the Government decided to give those shareholder a $10 gift per share.

I'm afraid that any logic or equity (pun intended) in the financial markets has gone AWOL.

2008 Sep 07 12:12 PM

[SW Richmond:]

obtricki,

The actual cost to the taxpayer is unknown. Even Paulson doesn't want to reveal it, so he has chosen the "dribble out" option. Freddie is reported to not have marked any of it toxic stuff to market, so the real writedowns there probably haven't even begun. A few hundred billion is not out of the question at all.

"The cost to the taxpayer is far outweighed by the impact that this takeover will have."

You seem very wise regarding the correct use of my money, even wiser than me. Do you work for the government?

"it does put an end to the doomsday scenario and the possibility of another Great Depression."

An end? Wow, that's a strong statement. So I should go long financials on Monday? A "generational buy" a la Dick Bove? The destruction of the dollar by adding this mess to the US government's obligations is ongoing. Too soon to call (yet another) bottom.


captainccs,

"I really don't see the logic or fairness of protecting one class of investors while wiping out another class."

The debt couldn't be wiped out or payments suspended, even on the subordinated stuff, as that would have triggered credit default swap claim events that no one wants to start. No one, except possibly Bill Ackman, who is a very smart guy that makes bets on the very reality which TPTB are trying desperately to avert.

Paulson is scared sh*tless of CDS, and rightly so. Many players have sold "insurance" in the form of CDS on fannie and freddie debt thinking it was as good as Treasuries. At the time it was like free money. These players now don't have the money to pay the claims if the debt goes bad, because no one has that kind of money anymore. A major CDS claims event would trigger a round-robin of defaults.

2008 Sep 07 01:27 PM

[The Cynic:]

Hmmm..., why protect bondholders and not stockholders?? Perhaps the anser depends on considering who the bondholders are and who the stockholders are. In the calculus of this decision, Paulson probably thought he could live with the possible hurt to the small banks and individual investors who have equity positions. But the large private institutions, central banks and foreign governments who have debt positions, well..., that's another matter.

2008 Sep 08 11:03 AM