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With every plan Treasury Secretary Paulson has come up with to instill confidence in financial markets, the costs climb higher and market confidence drops lower. Paulson originally believed he could instill market confidence by injecting selective moral hazard into companies that he believed needed to be marginally saved to stave off a greater collapse in financial markets. In the Paulson doctrine of moral hazard, certain company stakeholders have gotten severely punished while others have not (and have actually made money off of moral hazard).

In the Fed’s $29 billion loan to facilitate JPMorgan’s (NYSE:JPM) purchase of Bear Stearns, common shareholders were virtually wiped out while preferreds and debt holders were protected. The government’s 79.9% equity stake in their conservatorship of Fannie Mae (FNM) and Freddie Mac (FRE), severely diluted common shareholders, preferred shareholders lost their dividend, yet bond and subordinated debt holders were protected. One of the most vocal lobbyists urging government takeover of Fannie and Freddie along with inflicting moral hazard on the shareholders was PIMCO, who made $1.7 billion on September 8 as a result of the government’s quasi-nationalization. Ironically, PIMCO’s call for moral hazard came back to bite them in the bankruptcy of Lehman Brothers.

It is still unknown how much the Fannie and Freddie conservatorship will ultimately cost the government. Quasi-nationalization has failed to instill confidence in foreign investors, and it had only a temporary effect on reducing mortgage interest rates. For all of Paulson’s talk about “protecting the taxpayers,” his ideological need to inflict selective moral hazard on Fannie and Freddie is going to cost taxpayers at least $3 billion. As I pointed out in a previous post, GSE shares are widely held by pension funds and retirees because of the implied government guarantee and the large dividends paid out by their preferred shares. The dividends are particularly important to retirees on fixed income in an environment of low interest rates and rising inflation.

Banks also own GSE shares. In fact, GSE preferreds were about the only shares the government permitted community banks to own. According to the Independent Community Bankers of America, about 800 of its members owned about $16 billion of Fannie and Freddie preferreds. In a September 22 letter to Paulson, American Bankers Association President & CEO Edward Yingling points out that nearly 27% of banks hold preferred shares. He estimates the banking industry’s total GSE exposure to be between $10 and $15 billion.

Paulson’s action to wipe out GSE preferred dividends is creating the very problem he claims he is trying to avert by demanding Congress approve his $700 billion plan to buy “distressed assets” from financial institutions. Paulson argues that if the government buys these distressed assets, financial institutions will have more capital to lend to businesses and consumers – Main St. But as Mr. Yingling points out in his letter, banks’ reduction of capital from not receiving GSE dividends is limiting their capital and therefore their ability to lend to Main St. Community banks are the heart of Main St. lending, and they own the largest amount of GSE preferred shares. Mr. Yingling states that every $1 of bank capital supports $7.6 dollars of lending; Paulson’s GSE action could result in a decline in bank lending between $76 and $114 billion!

The Wall Street Journal reports that Congress is considering special tax relief for banks that own GSE preferred shares, estimated to cost the government at least $3 billion. Congress needs to approve a special provision since current tax law does not permit banks to deduct the losses on their GSE shares except as “capital losses.” With few banks having capital gains in this economic environment, banks are requesting that Congress allow them to record their loss as an “ordinary loss.”

The underlying resistance to Paulson’s latest and most expensive attempt to unlock financial markets comes down to what Fed Chairman Bernanke yesterday referred to as “market psychology.” Congress and Main St. are annoyed that Paulson is spending government money on silver bullets that never reach their intended target. Now that his gun has run out of bullets, he’s trying to scare America into giving him a nuclear warhead.

Disclosure: Long FRE and JPM

Source: Negative Return on Investment on Paulson’s Moral Hazard