President Bush also wanted fast action on his latest proposal to rescue Fannie Mae and Freddie Mac in Congress. He strongly endorsed Treasury Secretary Henry Paulson's plan but asserted definitively that the two companies would continue to be held by private investors. Bush also rejected the notion that the government would bail out any private enterprise.But, but... government support for Fannie Mae and Freddie Mac that doesn't wash out current equity holders is... ummm, how shall we say this... exactly what a "bail-out" is. If we provide financing to keep Fannie and Freddie up and running but leave the equity holders in place, when their shares are underwater, we are bailing them out!
The best summary I've seen of the Fannie/Freddie situaton -- history and current problems -- is by Tanta at Calculated Risk. As they say, read the whole thing. Looking at the core function of the GSEs (government sponsored enterprises) -- which is to provide liquidity to the mortgage origination markets -- she explains:
They have always been about recycling lending capital and taking long-term fixed interest rate risk off depository (and eventually non-depository) lenders much more than about merely absorbing credit risk. This goes against the grain of much current media over-simplification of "securitization" of mortgage loans that sees laying off credit risk as the main or even the only point of selling loans. The GSEs do take on the credit guarantee obligation of the securities they issue, but nobody sells loans to the GSEs just to offload credit risk--in fact, more than a few lenders work hard to negotiate contracts with the GSEs that leave quite a substantial part of the credit risk with the original lender: recourse agreements, indemnifications, servicing options that put a lot of the cost of default on the seller/servicer, not the GSE. They have historically done this because the credit risk of GSE-eligible loans has always been modest, but the benefits of getting 30-year fixed interest rate loans off your balance sheet has been substantial.
For decades, I have believed that Fannie and Freddie either should not have been privatized or should have been more strictly reined in. They serve, and must continue to serve, a critical function for US (and gobal) debt markets. But they're not ordinary financial institutions. They are public utilities which shouldn't be managed, as private financial institutions are, primarily for the benefit of the holders of their capital base (as currently structured, common and preferred shareholders) and their management.
The backing of the Federal government is the sine qua non of these institutions' existence and successful functioning. Without that implicit guarantee, they would never have fulfilled their public roles -- providing reliable liquidity to the mortgage markets in good times and bad, and setting widely-adopted standards for loan origination and servicing, which made the development of a healthy mortgage-backed securities market possible in the first place.
In recent years, managers and shareholders of the GSEs grew sloppy and forgetful about the real nature of these institutions. They forgot the instiutions were public utilities and that they had a duty to protect the implicit guarantee which made their business possible. Instead, they adopted the same expectations as typical corporate management and equity holders, with a focus on growth, retaining market share in a rapidly growing and increasingly risky market, and pumping up earnings, in order to justify huge executive compensation packages and higher share prices. They also had a lousy corporate governance structure, about which critics on both left and right have complained for years.
When housing market innovations started leaving them behind, instead of sticking to their knitting, they went running to Capitol Hill, where they enjoy enormous power on both sides of the aisle. They were allowed to stray into parts of the housing bubble where they didn't belong while simultaneously ignoring and taking advantage of the implicit government guarantee. Their behavior helped to magnify the overall size of the housing bubble and delay its bursting. (See Tanta for a nice summary of recent history.)
Today, the leverage ratio of Fannie's equity to on- and off-balance-sheet liabilities is, depending on which measure one uses, between 68:1 and 128:1. By comparison, leverage for a healthy private financial institution is likely to be in the range of 10:1 to 20:1, depending on what lines of business it is in. The implications of that excessive leverage are spelled out in a restructuring plan proposed by hedge fund manager William Ackman of Pershing Square Capital Management. (See attached pdf, which is an excellent view of the situation, regardless of what you think of Ackman's proposed solution). As Christine Richard of Bloomberg explains:
Ackman, 42, has his own plan that would see Fannie Mae raise about $86 billion in capital by giving investors in $750 billion of senior unsecured notes 90 cents on the dollar in debt of a new company, with the balance in equity. Investors in Fannie Mae's $11 billion of junior debt would get warrants, while common and preferred shareholders would get nothing, according to Ackman.
``We've not yet heard Secretary Paulson's plan but it would be a grave error for the government to invest in the equity of Fannie Mae and Freddie Mac as they are currently capitalized,'' Ackman, who oversees $6 billion at Pershing Square Capital Management in New York, said in a telephone interview.
[snip]
``The good news is that Fannie Mae has all the capital that it needs,'' Ackman said. ``It just has the capital in the wrong form with too much debt and not enough equity.''
Ackman also suggested the government put in place a stand-by purchase commitment for the new common stock for three years. The government is unlikely to be asked to buy any shares as there would be market demand for equity in the better-capitalized companies, Ackman said.
Although much has been made of the declining quality of the GSEs' portfolio, Ackman's plan shows how the structure of their balance sheets is at the heart of their current difficulties. Even if they hadn't wandered into high risk business, given how highly leveraged they are, Fannie and Freddie would today be nearing the point where the government guarantee would be called into play simply because the drop in housing prices nationally has been so large. The rule of thumb for Fannie's plain vanilla mortgage financing is a minimum 80% Loan to Value (LTV) ratio. That means, in some regions of the country, a large number of mortgages will now exceed the current value of the underlying real estate even if they continue to be performing. That's not the "fault" of the GSEs and doesn't suggest they should stop doing business -- as the housing sector continues to collapse, they are needed now more than ever. Being able to ride through periods of large drops in underlying asset values and growth in non-performing assets is one of the reasons why we have the GSEs in the first place.
In effect, the GSEs are designed to be "bailed out" by the government when market conditions demand. When the government steps in, the GSEs require restructuring and new capital, with existing equity being heavily diluted if not wiped out. That didn't really matter when the government owned the institutions. But when they were privatized and the equity in the GSEs was sold to private investors, the share price should have reflected the risk of dilution if the goverment's implicit guarantee was called. Yet that wasn't the case -- the GSEs behaved, and the market priced their shares, as if there was no risk that the guarantee would be necessary even though their balance sheets were built on the basis of the implicit guarantee. The recent plunge in their share prices is simply the market finally pricing the GSE equity to reflect the central fact that defines their business.
As many have observed today, yesterday's prohibition by the SEC against naked short positions in the shares of the GSEs is either simply political theatre or a case of the panics. (See e.g., Dean Baker, Dealbreaker, Felix Salmon). There are other ways than naked shorts for investors to bet, so the objective of the move is unclear. In any event, even if it Cox's game slows the price decline, it isn't going to make those shares worth any more than they already are, which fundamentally is zero.
The only thing which allows the shares to retain any market value is the political optics against "nationalization" of the GSEs. Together with President Bush's comment, the SEC's concern with the declining market price of GSE shares suggests that, although Treasury Sec Paulson hasn't described the conditions under which the government would provide an equity injection, nonetheless a figleaf of private equity will have some sort of role.
By trying to discourage a fall in share price, the government seems to be encouraging investors to believe in fairy tales -- that a restructuring may not be necessary or that current equity holders may not get washed away entirely in the restructuring-to-come. But if leverage ratios are to be brought down to somewhere closer to earth, new private equity won't come in without the existing equity being washed out. If existing equity holders retain a place in a new capital structure, it will be only because, in effect, the government has provided equity financing at rates far below what the private sector would demand.
Contra President Bush, there's going to be a bail-out. The only questions are how and how much. Retaining a role for private investors in the GSEs as Bush and Cox appear to suggest -- without restructuring the roles of the GSEs and their balance sheets -- is the very essence of the worst kind of government bail-out. Privatize the profits and socialize the costs.
Cross-posted at American Fooprints.
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