Treasury: "Honey, I Just Shot the Banks"

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


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  1. DaddieMac

    The treasury was caught between a rock and a hard place here. They could take F/F into “conservatorship” and use tax money to pay dividends; especially when the companies were not making any money. I think the banks are lucky they didn’t wipe out the shares altogether. It was important to make to bonds whole so that future F/F debt sales would be doable. There were plenty of signs that F/f were in trouble and a prudent investor would have sold.

  2. Peter T

    Fannie and Freddie were privately hold companies who distributed dividends despite being on the brink of insolvency for quite a while. No more treasury money should be poured into that hole. Indeed, it would have been better if PAST bonds would have not received any guarantees, after all their holders could have read it on the bonds. Future bonds could not be sold without explicite government guarantee, of course.

  3. Matt Dubuque

    I think Paulson is in over his head.

    Bush needs to replace him with former Treasury Secretary James Baker (a Republican and ally of the Bush family) in his place.

    Baker is the best Treasury secretary in the last 50 years and we need him desperately.

    Additionally, Bernanke gets thanked for his best efforts and asked to continue his outstanding research AND publishing in monetary policy at Princeton. I look forward VERY much to reading it. He’s one of the best in the field at academic research. Different skill set than being head of the Fed, however.

    Paul Volcker needs to then be asked (indeed begged) to fill in for 18 months. If Volkcer refuses, we need Geithner in that spot.

    Recall how Iraq didn’t approve until Bush finally brought in Petraeus. Bush is too loyal to those who have failed to perform.

    We don’t have the luxury of time.

    The buck stops with Bush.

    He needs to make these changes.

    You’re doing a heckuva job Brownie.

    The George Bush crack suicide crisis management team.

    Let’s put in Volcker and Baker.

    Matt Dubuque

  4. LJR

    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?


  5. FairEconomist

    Dizard is completely out of touch with reality. He thinks that because the endangered institutions *need* 400 billion that they can raise it by issuing preferred. Well, Fannie and Freddie basically were able to raise *nothing* by the end. Nor WAMU or Lehman. It would be crazy foolishness to bail out equity holders and create a massive moral hazard and additional loss to the taxpayer for chasing a phantom like that.

  6. curious-er

    With all due respect, the banks had shot themselves a long time ago. At best (or worst?) the Treasury’s move on the preferred can be described as removing the band-aid, which wasn’t doing much good anyway for some of those zombies.

  7. Anonymous

    I agree with most of the comments. Even if Treasury had saved the FNM and FRE preferreds, that would not have necessarily been a signal to the market that all preferreds in all banks would be similarly saved by Treasury. Treasury saved Bear Stearns but balked at saving Lehman. Saving the FNM and FRE preferreds would have still left vague ideas about whether the next institution would see its preferreds saved. Hard to believe $400 billion would have been raised in new preferred even if the FNM and FRE preferreds had been saved.

  8. Richard Kline

    FNM, FRE, LEH, and plenty more have been doomed to insolvency by the nature of their books for fourteen months. By any normal standard, their preferred paper has been effectively worthless. For the Treasury to ‘bail out’ the preferreds at the GSEs amounts to a gift of money, nothing more. Yes, speculators are going to be reluctant to put money into financial _existing_ financial institutions in consequence—and they should be: many of them are similarly gorked. The scale of impending capital losses is far, far beyond the ~$40B Dizard posits; there was never the slightest possibility that issuance of preferreds would suffice to ‘recapitalize’ the banking system. He is correct that we need a comprehensive plan to accomplish this, and that we lack one, and that the present public financial authorities lack the moral, political, intellectual, and ‘spine and gut’ capital to do any such thing. None of this is new; fourteen months and counting.

    If there is blame for the Treasury in its conduct on preferreds, it was in jawboning and sweetalking speculators into buying preferreds earlier in 08. That was a fast way for them to lose their dough, but if they were expecting that the Guvmint would stand behind them after they were all in they found out only too late the MO of the Bushies and their ilk, through seven years everywhere and now at the Treasury, i.e. ‘suck you dry and leave you cryin’.’ What we have _really_ seen this year with the purchase of preferreds, which Dizard does NOT manage to get his head around, has been speculators looking to snap up whole chunks of brand name money machines on the cheap with prices depressed. Oops, them’s been ‘Depression’ prices boys, and ya’ll are feelin’ it now, no? DON’T blame the Guvmint for your greed or the consequences, or come crying to the public for a do over or lump o’ sugar.

    When we do, finally, come up with a plan to recapitalize the banking system, speculators will have something to invest in. But pouring their wealth into existing, dying financial behemoths is, well, not too smart. Rotting dinosaur haunch can make ya ill; yes, really, wizards’ blessings nothwithstanding. Cavaet emptor, buddies.

  9. Yves Smith

    Folk, you need to get on top of the facts. The Fed did not wipe out the common, merely diluted it. Pray tell, what was the point of leaving the common shareholders in place with 20% of the equity? Common should have been wiped out and preferred saved. And remember, you are just stealing from Peter to feed Paul. Who pray tell is going to eat the losses on the preferred held by banks if there is no way for them to raise new dough? I suggest you look at your wallet.

    Do you think the public at large has the foggiest idea of the details of these deals? All the Treasury needed to do to make this deal optically acceptable was throw out the CEOs and shoot the common shareholders, No one but the financial community would have thought to ask about what happened to the preferred.

    And this WAS hugely short-sighted. Preferred stock was the last best hope for banks to raise money. For dividend payment on $36 billion of preferred (which is not a big number relative to the size of Freddie and Fannie) the window was shut for future fundraisings. Now the only game in town is the public purse.

    The Treasury could always have cut the preferred dividends later if banks were no longer able to raise fund via preferred stock. This was an unnecessary bit of friendly fire.

    See this Bloomberg story on the market reaction after the conservatorship was announced.

    Paulson’s “actions have damaged the preferred market,” said Thomas Hayden, the investment strategist for Liberty Bankers Life Insurance in Dallas. “Somebody is going to be looking at an issue of Fannie or Freddie preferred shares that were rated AA up until a few months ago. If that’s not money good then what about the small regional bank in some part of the country?”

    Hayden, whose $1.5 billion fixed-income portfolio contains preferred shares of Fannie and Freddie, said he’s “not interested” in buying any more preferred securities.

    The market’s tumble is making it more expensive for banks and brokers trying to raise fresh capital after taking $506 billion of writedowns and losses on the collapse of the subprime-mortgage market….

    The takeover was “unambiguously bad” for preferred investors and “likely set a precedent for any future rescue transactions,” Kathleen Shanley, an analyst at bond research firm Gimme Credit LLC in Chicago, wrote in a Sept. 7 report…

    Freddie preferred shares have lost 83 percent the past two days, while Fannie’s have declined 80 percent, the biggest losers in the Merrill index. The two companies account for about $24 billion of the $190 billion par amount in the index. Forty of the top 50 issuers have declined in the last two days…

    Citigroup Inc., the fourth-biggest U.S. bank by market value, lost $450 million this quarter on investments in Fannie and Freddie, including writedowns on preferred securities, the New-York based bank said in a filing today. E*Trade Financial Corp. will have a pretax loss of $150 million this quarter from selling its shares, the New York-based company said in a filing…

    “In the primary market it’s going to be much more difficult for financials across the board,” Hayden said. “If Lehman Brothers thought they needed to go to the market and had any chance at all of issuing preferred stock to raise capital, it is now three times more difficult than it was last Friday.”

  10. Anonymous

    For every action there is a reaction. The more they do to try and stop this the worse it will get, the longer it will last, and the more phantom wealth will be destroyed along with eventually the currency.

  11. Richard Kline

    I agree with your sentiments, Yves, but not the timeframe. The banking system will need preferred purchasers to make it, yes—after The Fall. Having those folks put in money now, _in the absence of a functional plan for the banks as a whole_ , simply throws that money away for the most part.

    What we need is A Plan. Yes, this may well involve nationalization as you know and has come up in comments, and public financial backing. —And the public should get something solid out of standing behind the financial system in the process in terms of the shape and functioning of said system. Once we have a plan, we'll be able to sell preferreds. But what we've had under Paulson & Co. is spin. All that has done is lose vulture speculators money. Sure, the wiping of preferreds at the GSEs is a bungle. These guys aren't capable of a non-bungle, so much is clear. The upside is that we may now be forced to come up with a real plan.

    Think about it: Why now? Why are LEH, WaMu, and AIG going down, with Merrill crawling under the nightgown of BoA? Cause with preferred buyers out it's GAME OVER. And about time. The longer we wait to end the sham and face up to the need for _a real Plan_ and with it realistic planners, the more money will be lost on non-solutions rather than solutions. That's a harsh view, but a larger one. Personally, I _want_ those capital holders who had been thinking of buying preferreds at dying institutions to sit on their wallets: We will need their dough soon enough once we are smart enough to stop losing it for them and stop them losing it for themselves.

    We can't resolve losses until we acknowledge that they exist. Paulson's bungle at the GSEs may have the unintended _good_ consequence of dragging the corpse into the living room.

  12. me
    “… Financial engineering has enabled firms to construct a wide variety of new “products” and instruments. However, just because a security can be created does not guarantee that it can or will survive in the marketplace. I suspect that many of the newly created products — for example, structured investment vehicles, or SIVs — may not return, or if they do, they will have a different form or contract structure. The message is that financial innovation as a whole is beneficial to society and has improved the functioning of our capital markets. That does not mean that every new innovation will succeed, but that is the nature of progress and we should take care that regulation does not unnecessarily inhibit such innovation….”

  13. Lune

    I respectfully disagree, Yves. I’m on Richard’s side on this one.

    If there was a mistake, it was Treasury asking banks to buy GSE preferred stock in the first place. If banks weren’t buying such stock in the first place, it was because in a strictly free market, capitalist sense, it wasn’t a good buy.

    These banks aren’t in the social do-gooding business. They didn’t magically buy those preferreds because they suddenly became patriotic Americans concerned about the common welfare. If Treasury convinced them to buy preferreds, it was by implying (sotto voce, and away from prying Congresspeople and journalists) a government guarantee that they would be protected in the very real event of the GSEs’ failure. That was the first mistake that pledged public funds to bail out private investors.

    What Dizzard is essentially implying is that by bailing out the GSE preferreds, Treasury could have hoodwinked other guys into thinking other banks’ preferred stock would also be bailed out, get them to put up some of their capital, then throw them under the bus at a later date. Exactly like the poker hustler who lets you win the first game in the hope that you’re fooled into making a bigger bet later on.

    Treasury shouldn’t be a hustler. They shouldn’t be in the business of implying govt bailouts or govt protection for certain classes of private investors, because those implications have a strange way of becoming ironclad guarantees.

    And if Dizzard isn’t saying Treasury should play the hustler, then he’s implying that once Treasury protects GSE preferreds, they’d be obligated to protect every bank’s preferreds, which is certainly not in the national interest.

    While you and Dizzard are correct that in the medium term (i.e. in the next year or so), bailing out the GSE preferreds would have brought some new capital into the market, that capital would only come in with the expectation of being made whole by the government. So in the long term, when those banks inevitably fail, all that “private” capital would be replaced by government money anyway.

    I guess what I’m trying to say is that while Dizzard accuses Treasury of extreme short-sightedness, he’s prey to the same criticism (albeit somewhat less shortsighted than Treasury). The fact is that much of the U.S. banking system is insolvent. Anyone with real skin in the game (i.e. without a govt guarantee) knows this and is staying away from these failing institutions, whether they get “preferred” or “senior preferred” or “super duper gold-star awesome CEO-will-wash-your-car” shares. The ultimate solution is to let the insolvent institutions fail, as painful as that is, and set the stage for the recovery.

    Dizzard’s horizon is only slightly less myopic than Treasury, and in the long term his solution is still the wrong solution. I’m actually glad that thanks to the Treasury essentially saying there will be no further bailouts of banks, that Lehman, Merrill, WaMu and others who have been limping along all year, are finally keeling over. Better now than 10 years from now after expensive govt life support.

  14. Yves Smith

    The top priority is recapitalizing the banking system, period. This has to be subordinate to ANY other policy action. That is not fair, and has bad optics, but this is one of those cases where no solution will look equitable. I did work early in my career on major corporate and financial institution stock and bond issues in the early 1980s, which was also a terrible environment, so I have some knowledge of public offerings under adverse market conditions.

    The ONLY example of an advanced economy coming out of a crisis of this magnitude is Sweden. They let banks fail but also immediately recapitalized them (as in pumped in public funds sufficient to cover the hole in their balance sheets with losses written down to the expected maximum level. The Japanese strongly urged us to do that, in public, a shockingly blunt move for them.

    Sweden is socialistic and accepted the necessity of that action. Japan is virtually a socialist nation, yet it took nine years to reach consensus to recapitalize the banking system. Pray tell, how long would it take in the US to get there? If it took Japan nearly a decade, would we ever get there?

    And we are really talking about being bailed out by foreigners anyhow. Japan had a high savings rate and could resolve its problems internally, in theory. Even if any recapitalization were nominally to come from the public purse, it would be funded by Treasury debt. Preferred gives a more diversified menu of financing options that appeal to different types of investors than Treasuries.

    The Fed and Treasury are not doing that or anything even close to that, Freddie and Fannie, which are banks of sorts, are on life support. They should either be shrunk or properly recapitalized. Ditto other banks, Instead, the powers that be are pursuing the worst of all worlds, letting institutions fail in a disorderly manner, and providing facilities to keep the debt party going. As Tim Duy pointed out, this merely shuffles debt around without actually bringing real resolution any closer:

    A solvency crisis can only be addressed by eliminating the bad assets (since analogies to Japan are all the rage, note that the unwillingness to eliminate nonperforming assets helped prolong that banking crisis). Moving the assets onto the Fed’s balance sheet via temporary repo operations does not eliminate the problem, it just moves it around.

  15. Dave Raithel

    At Yves Smith’s suggestion, I have been reading up on the Swedish solution. A summary given by Vice riksbankschef Lars Heikensten can be found at:

    Here’s why we probably cannot pull it off (from Section 5, point 5 of the address):

    “On top of this—and perhaps the most important factor— there was political consensus. The government sought and received backing from the main opposition party. That party was also allowed to appoint Board members of the Bank Support Authority so that it could be continuously informed and influence decisions. That was important both for political legitimacy at home and for credibility abroad—investors could be sure that the system we had created would be upheld even if there were a change in government.”

    We are simply too politically and culturally undeveloped. Considere whether we could agree as desecribed below (quoting again, Section 4, point 3):

    “A common framework of measures was constructed for support of the banking system. A strategy for deciding which banks to reconstruct and which to liquidate was developed and explained to the general public. The measures were designed to minimise costs for the Government and the risk of moral hazard. Consequently, shareholders were not covered by the government guarantee and would lose their equity investments to the same degree as the Government had to provide support for their banks. This provided an incentive to the owners to avoid applying for state support unless it was absolutely necessary, to minimise the amount of support and to reduce the time-period of receiving support. We used a very simple, but clear and easy-to-explain, method of identifying banks which should be given support in order to survive and those which should be liquidated or merged. First you write-down the bank’s bad loans. Then you test the bank in a micro- and macroeconomic model. If the model indicates that the bank will be adequately profitable again in the medium-term future it should be given support to survive. But if the model indicates that the bank will never be profitable again the bank will not be of economic benefit to the society and should thus be closed or merged in an orderly manner.”

    From my reading of the range of comments at NakedCapitalism and other blogs I link to from here, I just really doubt it. My point is not to dismiss her suggestion – I think she’s more right than anyone else whose ideas I encounter. But I’m too much like the protagonist in “There Will Be Blood” – I mostly see the worst in people, especially when it comes to money matters …. Course, I’d not complain if everyone proved me wrong.

  16. Richard Kline

    So Yves, I definitely agree with you that shuffling bad securitized assets back and forth between banks and the Fed is a bad mid-term move, even in the instances where, as you’ve said and I concur, it can be a clever short-term move. So if, after selectively and messibly wiping preferred holders at banks the Fed than goes on to push bad paper around rather than turn to Congress and put a plan together, than yes, we’ll have the worst possible outcome: Endless public rollovers but no solutions desirable to private recapitalization. Paulson has nothing better to offer, so we won’t get anything substantive until after the election at least, and more likely six months from now.

    But again, it is in the interests of our major foreign lendors, who will in time have significant participation in recapitalizing the US banking system, directly or indirectly, to get us up and running again. They will need to see a real plan, which is going to involve asset markdowns, and in many cases asset strip outs, and the kind of comprehensive regulatory oversight we sadly lack, all of which will take time. Doing bitty preferred raises only delays said markdowns, stripouts, runoffs, and re-regs. The only way we could get an orderly as opposed to a disorderly de-lev would be if the public authorities had the stautory authority to seize fail-ing banks or bank like firms and put them down—which said authorities do not have as you’ve discussed even moe than most in the blogosphere. So we will have a bumpy ride down, but there seems to be little alternative. Bitty chocks of preferreds only delay reaching a stable lower plateau where we can start a bank recovery. Or so it seems to me. If there’s a different and better way, I’m all ears.

    The money that was in financial institution preferreds, or considering getting in, will want to get back in when they have sound banks to buy into; this is where the money is after all. So I would like said investors to stop wasting their dough on spoiled banks, and to demand the reforms necessary to put potentially profitable banks back in action. Instead of acting like vultures trying to snap up blue chips with Federal guarantees or at least with sweetheart rates and eight-figure unlimited repos.

  17. Blissex

    «Pray tell, what was the point of leaving the common shareholders in place with 20% of the equity?»

    Ahhhhh and I thought that you were cynical enough.

    There are very good *formal* reasons to do that. It has been done with AIG too.

    Note that in both cases the “nationalization” was done in the same way: the Fed/USA were issued free stock in exchange for something else, like making a loan.

    Formally this means two things:

    * Both are still listed companies, just majority owned by the USA/Fed.

    * In both case *no money* has been spent by the USA/Fed. Just a loan.

    * In both cases the 80% threshold has not been quite reached. I think that is significant for listed companies.

    Basically, smoke and mirrors, shysterisms tricked by clever securities/government lawyers to work around some pesky legal details like section 8 of the USA constitution that vests in Congress the power to appropriate funds.

    The end result is that the Fed, ends up selling mortages and insurance policies, and the FDIC guarantees the trading losses of investment banks.

    What next? Perhaps the SEC and the Fed will get the power to wiretap without warrant communications among short selling “financial terrorists”, and the Fed will start snatching those “financial terrorist” short sellers from the street for rendition to Guantanamo or friendly countries that practice enhanced interrogation.

  18. Blissex

    «Pray tell, what was the point of leaving the common shareholders in place with 20% of the equity?»

    To be more blunt: the Fed currently is a hedge fund that owns a few off-the-balance-sheet SIVs, the mothers of all SIVs, for the USA Treasury.

    Just like with Enron SIVs, one of the keys is to retain enough of a third party stake that technically it is not a part of the controlling entity. So GSEs and AIG must remain public/private partnerships, and must remain listed on the NYSE.

    Again, Enron at least had the decency of hiding their SIVs, the USA treasury is far more brazen…

  19. Blissex

    «What next? Perhaps the SEC and the Fed will get the power to wiretap without warrant communications among short selling “financial terrorists”, and the Fed will start snatching those “financial terrorist” short sellers from the street for rendition to Guantanamo or friendly countries that practice enhanced interrogation.»

    Well, I was being sarcastic here, but guess what, the situation is so delirious that Cramer claims that some of that may be happening:

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