Fannie, Freddie: What Paulson Learned From the Pentagon

Includes: FMCC, FNMA
by: Rick Newman

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.

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