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Sunday, September 07, 2008 2:19 PM


Paulson Rolls The Dice At Taxpayer Expense


The GSE deal has been announced. Here is the Statement by Secretary Paulson on Treasury and FHFA Action to Protect Financial Markets and Taxpayers.

The title of the statement suggests two things.

1. This agreement will not reduce risk on the financial markets
2. This agreement will not protect the taxpayer

Let's take a look at excerpts to see how long it takes to verify that cynicism.

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.
My Comment: That statement clearly spells out that increasing systemic risk will be ignored at a "modest rate" through the end of 2009. Then, assuming one believes the second statement (I don't) the portfolios will be reduced at a rate of 10% a year starting in 2010. This implies banks will be in condition to start taking over where GSEs left off in 2010. I doubt it.
Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth.
My Comment: In theory this is a bottomless sinkhole, especially in light of the fact that systemic risk will be increasing over the next 16 months (and probably beyond that).
This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.
My Comment: The previous paragraph is a blatant lie. Various Fed officials have repeatedly said that the GSEs posed a systemic risk and that GSE debt was not guaranteed by the government. The only ambiguity comes from people like Bill Gross and other speculating that when push came to shove a government bailout would ensue.
The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets.
My Comment: There is a second statement that shows the increased systemic risk. How much is buried in another document that we will take a look at in a moment.
Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS. During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we've seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability.
My Comment: I am the only one I know who called for mortgage spreads to widen vs. treasuries on account of increasing default risk. By purchasing GSE MBS the taxpayer is increasingly at risk. It remains to be seen just how "temporary" this all is.
Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury's temporary authorities in December 2009.
My Comment: Holding to maturity does not guarantee no losses. It ignores foreclosures, defaults, walk-aways etc. Because those risks are high, lending standards need to improve further or mortgage rates need to remain elevated. This is in conflict with the idea of reducing the risk spread to treasuries. There is no free lunch.
Because the GSEs are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking.
My Comment: It should be perfectly clear that the GSE were never managed with a strategy to maximize common shareholder returns. That Fannie and Freddie guaranteed MBS they issued is proof enough. So is their current share price.
In the end, the ultimate cost to the taxpayer will depend on the business results of the GSEs going forward.
My Comment: That is an explicit statement that shows the taxpayer will NOT be protected.
Through the four actions we have taken today, FHFA and Treasury have acted on the responsibilities we have to protect the stability of the financial markets, including the mortgage market, and to protect the taxpayer to the maximum extent possible.
My Translation: Maximum Extent Possible is 1 chance in 36. This is like a crap shoot with a bet on 8 the hard way. (4 4).
And let me make clear what today's actions mean for Americans and their families. Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today.
My Comment: Hmm. How long ago was it that Paulson said "This is the strongest global economy I have ever seen."

Statement Bb FHFA Director Lockhart

To understand the exact deal one must look at a few other documents. Inquiring minds are reading the following.

Here is a Statement Of FHFA Director James B. Lockhart.
Fannie Mae and Freddie Mac share the critical mission of providing stability and liquidity to the housing market. Between them, the Enterprises have $5.4 trillion of guaranteed mortgage-backed securities (MBS) and debt outstanding, which is equal to the publicly held debt of the United States.

Enterprises will be allowed to grow their guarantee MBS books without limits and continue to purchase replacement securities for their portfolios, about $20 billion per month without capital constraints.
"Modest" Defined

We now have our definition of "GSEs will modestly increase their MBS portfolios through the end of 2009." The meaning is 16 months * $20 billion a month or an additional $320 billion.

However the systemic risk increases much faster than that. It is newer loans that are more at risk than older loans.


Q & A on Conservatorship

The Federal Housing Finance Agency released this Q & A on Conservatorship. There was nothing worth discussing in the document.

Fact Sheet: Treasury Senior Preferred Stock Purchase Agreement

The Treasury Department Office of Public Affairs spelled out the details in a Fact Sheet On The Senior Preferred Stock Purchase Agreement. Here are the key terms:

  • The agreements are contracts between the Department of the Treasury and each GSE. They are indefinite in duration and have a capacity of $100 billion each, an amount chosen to demonstrate a strong commitment to the GSEs’ creditors and mortgage backed security holders. This number is unrelated to the Treasury’s analysis of the current financial conditions of the GSEs.

  • If the Federal Housing Finance Agency determines that a GSE’s liabilities have exceeded its assets under generally accepted accounting principles, Treasury will contribute cash capital to the GSE in an amount equal to the difference between liabilities and assets. An amount equal to each such contribution will be added to the senior preferred stock held by Treasury, which will be senior to all other preferred stock, common stock or other capital stock to be issued by the GSE.

  • These agreements will protect the senior and subordinated debt and the mortgage backed securities of the GSEs. The GSE’s common stock and existing preferred shareholders will bear any losses ahead of the government.

  • In exchange for entering into these agreements with the GSEs, Treasury will immediately receive the following compensation: $1 billion of senior preferred stock in each GSE. Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price.

  • The senior preferred stock shall accrue dividends at 10% per year. The rate shall increase to 12% if, in any quarter, the dividends are not paid in cash, until all accrued dividends have been paid in cash.


Analysis Of Stock Purchase Agreement


Common shareholders will take an immediate 80% haircut.

The treasury is willing to risk up to $200 billion taxpayer money ($100 Billion for each GSE) on this absurd bailout.

Fact Sheet: GSE Mortgage Backed Securities Purchase Program

The Treasury Department Office of Public Affairs spelled out the details in a Fact Sheet On The GSE Mortgage Backed Securities Purchase Program. There is not much worth discussing in that document.

Fact Sheet: GSE Credit Facility

The Treasury Department Office of Public Affairs spelled out the details in a Fact Sheet On The GSE Credit Facility. This is an interesting document.
The Government Sponsored Enterprise Credit Facility (GSECF) announced today by Treasury to ensure credit availability to the housing GSEs is a lending facility that will provide secured funding on an as needed basis under terms and conditions established by the Treasury Secretary to protect taxpayers.

Fannie Mae, Freddie Mac, and the Federal Home Loan Banks are eligible to borrow under this program if needed. The facility will offer liquidity if needed until December 31, 2009. The Housing and Economic Recovery Act of 2008 provided Treasury with the authority to establish this facility.

The Government Sponsored Enterprise Credit Facility (GSECF) announced today by Treasury to ensure credit availability to the housing GSEs is a lending facility that will provide secured funding on an as needed basis under terms and conditions established by the Treasury Secretary to protect taxpayers.

Fannie Mae, Freddie Mac, and the Federal Home Loan Banks are eligible to borrow under this program if needed.

The facility will offer liquidity if needed until December 31, 2009. The Housing and Economic Recovery Act of 2008 provided Treasury with the authority to establish this facility.

Loan Duration, Rates, and Size
  • Loans will be for short-term durations and would in general be expected to be for less than one month but no shorter than one week.

  • Specific maturities will be determined based on individual loan requests.

  • The term of a loan may not be extended, but a maturing loan may be replaced with a new loan under the same borrowing procedures as the initial loan.

  • Loans may be pre-paid with two days notice, and loans may be called before their scheduled maturity date.

  • Loan amounts will be based on available collateral.

  • Loans will not be made with a maturity date beyond December 31, 2009.

  • Rate. The rate on a loan request ordinarily will be based on the daily LIBOR fix for a similar term of the loan plus 50 basis points (LIBOR +50 bp).

  • The rate is set at the discretion of the Treasury Secretary with the objective of protecting the taxpayer, and is subject to change.

  • Collateral. All loans will be collateralized and collateral is limited to mortgage backed securities issued by Freddie Mac and Fannie Mae and advances made by the Federal Home Loan Banks.

  • The collateral will be valued and managed by Treasury’s fiscal agent, the FRBNY, based on a range of pricing services.
Analysis Of Lending Scheme

At taxpayers risk, the Treasury will lend up to $200 billion to the GSEs at a mere 50 basis points over LIBOR. This is a massive Asset Backed Commercial Paper (ABCP) scheme sponsored by the Treasury at taxpayer risk.

Supposedly the rate will be set with the objective of protecting the taxpayer and can vary.


Assuming the GSEs do borrow $200 billion, exactly how are they supposed to pay it back December of 2009?

Who's Last In Line?

Let's return to the first document for a look at "Who's Last In Line?"
Market discipline is best served when shareholders bear both the risk and the reward of their investment. While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses.
Common shareholders are "last in terms of claims on the assets of the enterprise". Preferred shareholders are next in line in terms of risk.

But what about the statement "Under these agreements, Treasury will ensure that each company maintains a positive net worth." Are preferred shareholders at risk under this arrangement or not? And what is it exactly that Bill Gross is holding?

Taxpayer Risk Defined

And what does the government (taxpayer) get for a potential $200 billion in lending while allowing the GSEs to add another $320+ billion of systemic risk?

The answer is a mere $1 billion of senior preferred stock in each GSE and Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price.

In other words taxpayers are rolling the dice on $200+ billion in risk backed by a lousy $1 billion in senior preferred stock and warrants on shares of common that are likely to be worthless.


Expect More Bank Failures


The FDIC issued this Statement On The Takeover of Fannie Mae and Freddie Mac.
The federal banking agencies have been assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two government-sponsored enterprises, a limited number of smaller institutions have holdings that are significant compared to their capital.
Limited Number?

Of course it's a limited number. It limited by the number of banks there are. The question is "How limited is it?" The second question is "What additional taxpayer risk is going to happen on account of it?"

It would be nice if the FDIC had the integrity to discuss these issues instead of hiding behind the word "limited".

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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