Negative Return on Investment on Paulson’s Moral Hazard

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 (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

Comments

[venividivici:]

Good article mate.

2008 Sep 25 10:31 PM

[Inzight:]

Look up Ron Paul's latest description of today's WaMu failed bailout / JP acquisition

"Socialism for the elite/rich" - truer words could not have been spoken

mining101.blogspot.com

2008 Sep 25 11:11 PM

[investor88:]

Wall Street Weather has written a good article, informative. Paulson's mega bailout plan doesn't instill much confidence, has all the appearances of a rushed proposal akin to instinctive fire fighting. High chance it may have unintended consequences or it doesn't really solve the underlying problems. There may not be a lasting solution and a new beginning when the US as a nation seems unable to accept the necessary medicine of recession and reforms that follows a period of extreme excesses.

2008 Sep 26 12:03 AM

[bigmik_98:]

If the Govt owns these mortgages and the homeowner cant make the payment is the govt going to be foreclosing on taxpayers and evicting them???

Could 700billion not be used to update Americas infrastructure to 21st century standard and to make America energy INDEPENDENT???

2008 Sep 26 12:07 AM

[madasiwannabe:]

The GSE takeover was an orchestrated power play. The downward spiral started when Paulson announced his plan for a backstop. Once in place, PIMCO did their best to shake investor confidence so they could buy government backed securities at Junk bond rates. One of their point men was non other than Greenspan. He's been on PIMCO's payroll for a while now as a consultant. He's also on the other big winner of Sept 8th's payroll, Pershing Square. They racked up a whopping 8 Billion.

The takeover also took, by my estimates, 36 Billion in shareholder/investor value out of the GSE's in a single day. We now know where 10 Billion of it went. Now the taxpayers will have to put it back before we can even start paying the rest of the tab. If we can use the S&L bailout as a benchmark, this will cost the taxpayers many Trillions before it's over.

2008 Sep 27 07:14 PM