Readers may recall that we were gobsmacked that the conservatorship of Fannie and Freddie involved wiping out dividends on their existing preferred stock. That was stunningly shortsighted move, guaranteed to be commemorated as a a major mistake when histories of this period are written.
Fannie and Freddie preferred were held by banks, so any losses on the preferred would reduce already stressed bank capital. But far worse, preferred stock was the best hope for financial firms to raise new equity. Trashing the Fannie/Freddie preferreds meant that any sane investor would worry that future bank rescues could similarly damage preferred shareholders, and they’d avoid financial firm preferred stocks, including new issues. And indeed, financial preferreds got whacked in the wake of the GSE bailout.
John Dizard, who had discussed in his Financial Times column how the authorities wouldn’t be so dumb as to trash the GSE preferred, assesses the damage now that they have done just that. And he has some choice observations about the competence of the Treasury crew.
From the Financial Times:
Readers will recall my belief that the value of the privately held preferred stock issued by Fannie Mae and Freddie Mac would be preserved, so as to maintain the value of an asset class needed to recapitalise the banking system.
I was wrong. The preferred shareholders, including a lot of banks, were thrown under the bus. They had been induced, with the encouragement of this team at the Treasury, to buy the stock to shore up the two institutions’ balance sheets.
Most of that stock was sold this year. Along with other people, I thought that much of the necessary capital raise for the banking system could be accomplished with the issuance of preferred, which would count as Tier One capital, but which would be much less expensive than common stock.
I wrote that the alternative to saving the value of the preferred would be direct Federal capital support for the banking system, and that this would be 10 times as expensive.
One financial commentator thought that I had a point, but that the 10 times estimate was “snatched from thin air.” Actually, no. To get the banking system back to something close to balance sheet health will require capital raises in the order of $400bn. The preferred stock value that disappeared with Mr. Paulson’s “rescue” was around $36bn. There you are.
Now, if Mr Paulson and his team had an alternative plan that made sense, some creation of structured finance magic that would leave us gasping at the genius of it all, that would be different. But no.
In his statement on the Fannie and Freddie actions, he said: “Preferred stock investors should recognise that GSEs [government-sponsored enterprises] are unlike any other financial institutions, and consequently GSE preferred stocks are not a good proxy for financial institution stock more broadly . . . the broader market for preferred stock issuance should continue to remain available for well-capitalised institutions.”
Not true, Mr Paulson. The market for bank preferred stock is effectively closed. It is not immediately obvious now how the banks can raise the Tier One capital they need to finance a recovery . . . scratch that, not a recovery, just the present level of economic activity.
I called a senior person in the housing finance sector to find out what the people inside the room had been thinking. Not much, it turned out.
“Their horizon is in the extreme short term,” he said. “By sucking the incentives out of these alternative instruments [such as preferred stock], they have created a materially serious long-term problem.
“They are incapable of rational long-term planning; for them every issue is a one-off event. As the rest of us know, though, that is not true.”….
The problem with opportunism is that it often isn’t opportunistic. The Treasury team has now shown its weakness. They’ve fired their “bazooka”, and we’re still in trouble. It is not completely impossible that their next problem will be how to recapitalise the Federal Deposit Insurance Corporation. That would be complicated by the intense antagonism that has built up between the FDIC leadership and the banks, the other regulators, and other housing finance people. Resolving that will require people with moral and political authority, as well as an understanding of the serious operational problems involved in such a work-out or restructuring. Ideas?
The good news for the US is that we have the chance to capture some flight capital coming out of some yet more screwed-up places, as we see from the currency market action and the Treasury curve.
Getting that money into the banking system will require considerably more skill than we have seen so far