Paulson Playing Chicken With Markets: Guess Who Will Win? (GSE Edition)

James Carville, Clinton strategist, said,

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody.

If a politico like Carville recognized the fixed income market as an irresistible force, you’d think a Wall Street pro like Henry Paulson would give it the respect it deserves. But peculiarly, he has been acting as if he can bluster his way through a mushrooming crisis of confidence in Fannie and Freddie.

A Barron’s report over the weekend saying that the Treasury would buy GSE preference shares (and wipe out equity holders) if the companies failed to raise new equity sent the shares into a downdraft, with Freddie’s falling 25% and Fannie’s, 22%, triggering a broader market fall in the US that continued overnight in Tokyo. More troubling, GSE debt also fell, as Accrued Interest reported:

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity. Even senior paper is 7-8bps wider on the day. MBS look to be only about 4bps wider.

I’ve heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he’s been up to his eyeballs in 100 bond lots today. Haven’t heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.

So what reaction did this mini-meltdown elicit from the Administration? The Wall Street Journal tells us:

In early July, a previous plunge in the companies’ shares prompted the U.S. Treasury to announce a package of measures aimed at shoring up investor confidence. Among other things, the Treasury said it would lend money to the companies or make equity investments in them if needed.

“As the secretary has said many times, we have no plans on using the authority,” Treasury spokeswoman Jennifer Zuccarelli said Monday, referring to Treasury Secretary Henry Paulson.

This is about as lame as it gets. I’m sure a PR pro could do better, but the right response is reassurance from Paulson himself: the markets are on the mend, yes, there may be bumps but things are getting better, we are on the case, will act if necessary but don’t see the need, Freddie and Fannie have plans in progress to improve their balance sheets. That probably wouldn’t undo what Barron’s hath wrought, but it would halt the slide and produce at least a partial reversal. Investors want to hear that the powers that be are engaged and willing to pull the trigger.

What is even worse from the Adminsitration’s standpoint is that savvy observers see the bailout plan as a sham. As the Financial Times reports:

The Treasury dismissed the [Barron’s] report as “speculation”. It told the Financial Times it still had no intention of using its newly authorised power to invest in either the debt or equity of Fannie and Freddie. The question is whether it may be forced to do so.

The logic of the plan unveiled on July 13 was that the market would be reassured by the Treasury obtaining authority to invest in Fannie and Freddie, reducing the likelihood that the government would actually have to bail them out….

“Hank Paulson’s gamble is that if the Treasury commits to investing in Fannie and Freddie [if required] it will never have to put money in,” said Alex Pollock, a fellow at the American Enterprise Institute.

In other words, this was all meant to be a bluff. But the markets have called the bluff in very short order. And given the lousy and certain-not-to-get-better-anytime-soon condition of Freddie and Fannie, this outcome was entirely predictable.

What is ever weirder about the Administration’s inept denials is that they seem to be quietly moving forward in examining rescue options. A Wall Street Journal editorial, “When Henry Met Fannie,” tells us:

Meantime, Treasury claims it has no plans to inject taxpayer money directly into the companies. Even so, Mr. Paulson has quietly hired Morgan Stanley, the investment bank, to look into “appropriate capital structures” if he does decide to sign the blank check that Congress has given him.

Robert Scully, the Morgan banker who will lead the effort, is by all accounts a straight shooter. And he will need to be, given the enormous political pressure he will soon face from Fannie Mae’s defenders, both at Morgan and in Washington. Morgan Stanley says it is forgoing any other investment banking business with Fan and Fred while it works for Treasury. But until recently it was among the banks advising Freddie on that elusive $5.5 billion capital infusion.

Morgan Stanley is also home to Kenneth Posner, one of the biggest Fan and Fred cheerleaders on Wall Street. Only last March, the analyst crowed about the “complete defeat” of the “anti-GSE ideologues” — that is, the people who had been right all long about the reckless risks the companies were taking. Mr. Posner also predicted that Fannie and Freddie would return to breakeven by the third quarter. Mr. Scully shouldn’t be caught in the same intellectual area code as Mr. Posner.

Disclosure: I knew Scully early on in his career. He is indeed as upstanding as they come in investment banking (yes, that is an oxymoron), very well regarded.

So why is Paulson unhelpfully (as far as market confidence is concerned) denying that he will salvage the GSEs, yet moving forward to develop plans to do precisely that? Oh, I forgot. The SIV rescue plan. Hope Now Alliance. Getting China to open its financial markets. Having JP Morgan buy Bear for $2 a share. Execution has not been the Adminstration’s or Paulson’s strong suit. Why should now be any different?

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  1. Anonymous

    Paulson might be pro-rescue but it might be the Decider saying no.

    Recall W’s “closed-door” comment that Wall Street has been on a drunken stupor and needs to clean up its act.

    Perhaps, (ironic considering W’s life story?) W’s hell-bent on having Wall Street get off its credit addiction cold turkey, consequences to the real economy be damned.

    Or perhaps W sees no problem, which also wouldn’t be a surprise as he stated directly during the Olympics to Bob Costas that he doesn’t see any problems in America.

    Oh, to be able to overhear the conversations between Paulson/Bernanke/W/Cheney. Move over Hoover and Nero.

  2. Anonymous

    I am curious as to what degree of power you and others here think the treasury has over the GSEs. At the moment, both have capital that is in excess of not only the statutory minimum but the required surplus over the statutory minimum. As long as that is the case, what grounds or authority does Treasury have to inject capital and wipe out existing shareholders? Wouldn’t that be something you’d see in Russia but not here? Do shareholders of the GSE’s have no property rights? No one would argue that they should be immunized against actual losses that the GSE’s may incur, but are they not entitled to await the outcome of the bets they’ve made with their capital, rather than just have treasury waltz in and confiscate the capital with a pre-emptive assertion that the capital surely is going to be lost anyway? Is it your opinion that a treasury injection can and will happen while the companies have excess capital, or is it your opinion that it is only a matter of time until they no longer have excess capital, at which time intervention would seem more justfiable?

  3. Peripheral Visionary

    One additional complicating factor in all of this is that FNM/FRE have a lot of support from a broad range of powerful individuals, but whose support is not quite altruistic; people in various positions of significance in government, the media, and the financial sector who are compromised because of direct ties to them.

    As long as FRE/FNM have so many politicians, media types, lobbyists, and even academics on the take, either directly or indirectly, it will be very difficult to muster public support for substantial reform and/or restructuring of debt at the GSEs. Instead, the favored solutions will be taxpayer-funded bailout packages that do not require difficult changes. This is one area where I am solidly behind President Bush; for better or for worse, and whatever the reason, his dislike of the GSEs has served the general public well in holding back the Federal government from giving in to the GSE’s every demand.

  4. S

    The fair valeu balance sheets are a sham. The entire excess capital is tied to def tax assets. Those are not fungible. hence they are effecietivly bankrupt. Excess capital is a sham measure. LEH hgas assured the markets every quarter that it has sufficent capital and yest has been reduced to talk of selling NB crown jewel.

    The notion that China was ever going to open its capital markets to the US was lunacy. It is shameful that Washington negotiated itself into a cul de sac for the past few decades. Now we have approx 0 leverage. tactics without strategy the surest way to defeat. Typical short termism in the USA. The Putin gambit kind of tells the story. The US has been reduced to talking tough and well talking tough (unless you are a third world/rate army).

    Hey, at least the US has convicned the GCC to maintain the pegs. One success. $ backed by black gold.

  5. Stuart

    AND , yet they won’t let Morgan look at the REAL books. Go figure that one .. ??! It all screams another sham.

  6. maynardGKeynes

    Big question out there: Is it clear that Paulson has the power in the first place to seize the GSEs (i.e., by wiping out equity holders through forced issuance and subsequent purchase by the government of preferred or other senior share classes), even if he wants to? People point to the recent recent legislation as giving him this power, but insofar as the legislation purports to authorize confiscation, it’s probably unconstitutional. Under the US Constitution, the government may seize private property for public use in one way and one way only — through the eminent domain process specified in the eminent domain clause of the Constitution. Indeed, Is anyone aware of the federal government EVER having seized a private company (other than an FDIC or FSLIC bank) in peacetime? As far as I can recall, the Chrysler bailout did not wipe out shareholders. In the case of the FDIC, the banks are private, but the FDIC insurance agreement explicitly provides this right of seizure. Bottom line is that the GSEs have NOT failed nor are they insolvent under US law. Unless that scenario changes, I doubt that they can be seized, except through the eminent domain power, which is quite cumbersome and too time consuming to provide the rescue in time to save the GSEs.

  7. Anonymous

    Wiping out the shareholders of Fannie/Freddie would trigger the financial collapse that was avoided by the Bear Sterns bailout. Some very large public agencies have billions invested in the GSE’s stock because they can only invest in government securities and bonds (backed by the full faith of the Us Gov’t. Even Greenspan says the guarantee is there even if disclaimed.). Some very large pension plans also have billions invested because even the most sophisticated investors viewed them a super safe. These would all collapse almost overnight if their investments were wiped out. The ripple effects would trigger the domino effect predicted had Bear Sterns collapsed.

  8. Anonymous

    Not to get all ‘strategery’ on you, but maybe Paulson **wants** us to think it was a bluff, because he always knew he would have to bail the two out. He wants to look like he exhausted all options (even a bluff) and then, lo and behold, was actually ‘forced’ into the bailout. A large contingent of taxpayers are going to be furious about bailing out bankers (including foreign central bankers). Isn’t Paulson’s paramount need here to look like he resisted this for as long as possible?

  9. Anonymous

    Let’s see, I can hazard a few ideas as to how to proceed that might stick.

    1. The GSEs operate pursuant to a Federal charter. The spreads the markets demand for their MBS is now putting their ability to perform their role as envisioned in the charter in jeopardy. Pulling their charters would put them out of business. That is not the simplest or most straightforward way to force GSE shareholders to accept being wiped out, but it would stick. No charter, no GSE.

    2. Both firms are regulated entities. Regulated financial institutions operate at the suffrance of their regulators. They have considerable authority to shut down their charges or force liquidations. I am not sure how far OFEHO’s powers go, but look what OFHEO did in reaction to the accounting scandals, and their intervention was comparatively mild. I don’t see any reason to think that OFHEO has less power than other banking regulators.

    Freddie is already operating with negative net worth on a mark-to-market basis. I have read things elsewhere that suggest that that puts it in violation of its operating requirements. Declaring FRE insolvent (or threatening to privately to force management to play ball) is a no-brainer. I am sure that Fannie is close enough to being out of bounds that it too could credibly be deemed to be insolvent, or at risk of being insolvent (reversing the deferred tax treatment alone puts them in negative net worth territory) to justify intervention.

  10. Chris

    Aren’t there kind of gross political time considerations in these kind of things? Now till the conventions, Labor Day to the Elections, elections to inauguration. Sometimes the name of the game is just to kick the can down the road. If they can’t get it into the next guy’s watch in one big kick, just keep it moving forward with little kicks, and hope nothing too bad happens. All a question of avoiding blame and accountability and dumping it in the lap of the next lot. Is there still time to buy more time?

  11. esb

    Paulson kicked the can into the air in July.

    It is still in the air.

    He thinks it will remain in the air until after the inauguration (of Obama) at which time it will come crashing down on his not-so- well insulated head.

    He is probably right.

    I have great sympathy for Obama, who will be entering into an office stuffed wall to wall with financial C4.

  12. lyubomira5

    Both FNM and FRE are insolvent at this point. In addition to not getting enough interest payments from mortgagees, they have recurring expenses like foreclosures (a foreclosure can cost up to $50,000 before it is all said and done), delinquent real estate taxes (which have to be paid since they are a higher priority lien than the mortgage). Add to that the declining value of collateral. They have a negative cash flow.

    Obvious options are:
    – chapter 11 bankruptcy protection from current creditors;
    – take over of the shares by the US government (which shares IMO are worth $0.00 even though they are still trading above that);
    – the US explicitly guaranteeing future debt and becoming first position bond holder for both (in front of all other bond holders).

    Over time borrowers will pay some o the debt, foreclosed property values will recover and this excercise can become profitable for the US as was the RTC (it did turn eventually a profit).

    The immediate concern, in Bernanke’s words is the triangle of risk, liquidity and capital. And the low interest rates will of course help stabilize things as treasury paper holders realize that treasury rates even at 4% and inflation of 5.6% means investors are losing 1.6% every year in real terms.

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