naked capitalism

The link is here. Main elements:

Common and preferred equity wiped out

Subordinated debt swapped for equity warrants

Current senior unsecured debtholders get per each dollar of face 90 cents face amount of new debt and 10 cents face amount of new equity

Equity holders can put common to Feds at face value for first three years

Overall, it has a lot going for it, namely simplicity plus limited duration and lower amount of government guarantee.

The problem is that this resturcturing still leaves the GSEs pretty levered. Using the example of Fannie, total gearing including guarantees 41.5x to common, 23.7x to total equity. But that’s a lot better than the current 128.9x and 68.7x, respectively. This kind of leverage is more in keeping with what you see at securities firms with (in theory) balance sheets composed significantly of liquid tradable assets and derivative positions that can be hedged. Of course, the assumption is that the GSEs have high quality assets, and Tanta has stressed that the GSEs absorb only a limited amount of credit risk:

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.

But as she elaborated further, in recent years (and recall that most mortgage paper is of intermediate term duration due to sales and refis, so “recent” is material in terms of what is outstanding) the GSEs moved further down on the risk curve:

But they didn’t like losing their market share, and they pushed the envelope on credit quality as far as they could inside the constraints of their charter: they got into “near prime” programs (Fannie’s “Expanded Approval,” Freddie’s “A Minus”) that, at the bottom tier, were hard to distinguish from regular old “subprime” except–again–that they were overwhelmingly fixed-rate “non-toxic” loan structures. They got into “documentation relief” in a big way through their automated underwriting systems, offering “low doc” loans that had a few key differences from the really wretched “stated” and “NINA” crap of the last several years, but occasionally the line between the two was rather thin. Again, though, whatever they bought in the low-doc world was overwhelmingly fixed rate (or at least longer-term hybrid amortizing ARMs), lower-LTV, and, of course, back in the day, of “conforming” loan balance, which kept the worst of the outright fraudulent loans out of the pile.

Thus one would presumably need to drill deeper to know if the proposed leverage level is appropriate.

Ackman also endorses the idea of having the GSEs write more business now. That’s a political necessity, but I’d be happier with a scaled-down version of a proposal of Martin Hutchinson, He wanted to wind down the GSEs, while the objective here would be to keep them around, but whittle down their share of the mortgage market (we’ve noted there are other reasons for not letting them get too big, for instance, the hedging of their book becomes nastily pro-cyclical and disruptive to the overall credit market). Freddie and Fannie’s pay scales would be cut sharply (if they are socialized entities, staff ought to be paid on civil service grades or not much above that, which giving plummeting employment in securities and banking land, would still leave the GSE able to attract decent people) and their fees increased gradually to reduce their role in the market. You’d need to play with spreadsheets to see how it netted out, but the GSEs have become too big a force for their and the collective good.

And if we need a “rescue housing” entity, as I have said before, I’m not a proponent, but it should be a new program with new staffing and guidelines, and not muddy up mortgage finance vehicles like Freddie, Fannie and the FHA, which have historically, and correctly, stood for sound lending.