It's been a busy summer. Treasury Secretary Hank Paulson engineered, Congress approved and the President signed legislation which will allow the Treasury to rescue, if necessary, ailing mortgage giants Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), which together issued or back half of the nation's $12 trillion of mortgage debt.
Fannie Mae and Freddie Mac, those curious, privately owned financial hybrids whose debt is “implicitly guaranteed” by the U.S. government (taxpayers), are “systemically important” to the nation, and to the world, for all of the reasons we can think of, and a few reasons we wish we didn't have to consider.
Systemic importance now has replaced the awkward and colloquial “too big to fail” to describe those financial institutions deemed worthy of special consideration. IndyMac Federal savings Bank, seized by the FDIC in July and shaping up to be the third largest bank failure since the FDIC was created in 1933 with potential losses of $4 billion - $8 billion, apparently was not considered systemically important.
The Bear Stearns Companies, however, was deemed systemically important, not because of its stature as an investment bank but because of its sizable off-balance-sheet derivatives exposure – it was too “interconnected” to fail and it's rapid implosion in mid-March led to a government-officiated shotgun marriage with the nation's largest bank, JP Morgan Chase.
Bear Stearns was regarded so systemically important the Treasury Department was willing to let the Federal Reserve accept $29 billion worth of potential losses (to JPM's $1 billion) to get the deal done over the weekend before trading in Asia began on Sunday night and in the U.S. on St. Patrick's Day.
Bear Stearns's common shareholders took a huge hit, eventually receiving $10 a share, down 94% from an all-time high of $172 a share in January 2007 before the storm hit.
Fed Chief Ben Bernanke, speaking recently at an annual Jackson Hole, Wyoming conference, said “some thorny issues are raised by the existence of financial institutions that may be perceived as 'too big to fail' and the moral hazard issues that may arise when governments intervene in a financial crisis.”
In his remarks, Bernanke confirmed the systemic importance of Bear Stearns, not by its size but because it was “involved in a number of critical markets, including those for over-the-counter derivatives. One of our concerns was that the infrastructures of those markets and the risk- and liquidity-management practices of market participants would not be adequate to deal in an orderly way with the collapse of a major counterparty.”
“With financial conditions already quite fragile, the sudden, unanticipated failure of Bear Stearns would have led to a sharp unwinding of positions in those markets that could have severely shaken the confidence of market participants,” he added. So there you have it: March Meltdown avoided.
“The broader economy could hardly have remained immune from such severe financial disruptions,” Bernanke concluded. Not uncoincidentally, JP Morgan Chase has the league-leading position in off-balance sheet derivatives, nearly $85 trillion of notional (face) value as of year-end 2007, compared with Bear Stearns's $13.4 trillion. It was estimated by merging the companies about $6 trillion of notional value derivatives were netted, which represented the value of contracts in which Bear Stearns and JP Morgan Chase were counterparties.
Dr. Bernanke is making his case for a FIRE economy (Finance, Insurance and Real Estate) super-regulator and observed the critical question now before us is “how to strengthen our financial system, including our system of financial regulation and supervision, to reduce the frequency and severity of bouts of financial instability in the future.” The moral hazard issue is valid: the temptation to act irresponsibly via excessive risk-taking based on a now not-unreasonable expectation of government intervention and bailout when necessary. “Mitigating that problem is one of the design challenges that we face as we consider the future evolution of our system,” the Federal Reserve Chairman noted.
He and his Fed, Treasury and SEC colleagues likely will have their hands full grappling with that one, which returns us to the
continuing saga of the nation's mortgage companies, Fannie Mae and Freddie Mac and Hank Paulson's “bazooka” rescue plan. (Paulson told legislators in mid-July, “If you have a bazooka in your pocket and people know it, you probably won't have to use it.”)
Market participants, however, may not believe Paulson's bazooka to be loaded, judging from response to the plan in the last month. “We’re in a Catch 22,” said an unnamed mortgage company executive in a recent New York Times story. “As long as there is uncertainty over Treasury’s plan, we can’t raise money, and as long as we can’t raise money, there’s going to be more and more speculation about Treasury’s plan.”
Said another unnamed investment professional quoted by the NY Times: “You would have to be insane to invest in these companies right now, and we’ve basically told them that. When Treasury comes in, they are guaranteed to get a better deal than us, which would push down the value of our investment. So why would we ever invest before we know what Treasury is going to do?”
Investors now appear unwilling to inject further equity into Fannie and Freddie until the scope of Treasury bailout is known, but the Treasury will try not to unlock the vault full of taxpayer money to bail out the mortgage enterprises until all market investment alternatives are exhausted.
Stalemate, at least for now, but both Fannie Mae and Freddie Mac are running out of time based on recent sell-offs in their common and preferred shares. Freddie Mac had announced it would seek $5.5 billion billion of fresh capital in mid-May when its stock traded at $27.50. At a current share price well-under $5.00, raising $5.5 billion now would be hugely dilutive to existing shareholders, assuming new shareholders could be found willing to take the risk of a possible imminent wipe-out of equity holders by the Treasury.
Perhaps telling, investor Warren Buffett, who in the past has done well rescuing down-on-their-luck enterprises, acknowledged in late August he had been approached by Freddie Mac but passed on an opportunity to buy a big stake. Buffett's Berkshire Hathaway once had been the largest shareholder in Freddie Mac, but said his investment company sold its entire position after 2001 when he said he realized both Fannie Mae and Freddie Mac “were trying to report quarterly earnings to please Wall Street.”
More ominously, the Treasury rescue plan has run into a buzz saw of criticism related neither to the “privatized profits/socialized losses” nor the “economic-importance-of-housing” arguments surrounding the controversial plan reluctantly signed into law by President Bush at the end of July. Almost immediately after the Treasury revealed the plan particulars, which would crush common stockholders and perhaps the preferred stock, much of which is owned by U.S. banks, creating another problem. As it would leave more than $5 trillion of debt unscathed, it has been suggested the plan was influenced more by the impact on the many foreign government owners of Agency debt, notably China.
In the July 30th Wall Street Journal, commentary author Stephen Moore suggested members of Congress who voted for the bailout authority eventually may be asked, “Why are you taking money from U.S. taxpayers to bail out the Bank of China?” Moore describes the Bank of China as the biggest supporter of possible Fannie Mae and Freddie Mac rescues, and no wonder: “the Chinese own a half-trillion of Agency debt and they've put the warning out to Treasury Secretary Hank Paulson they expect to be paid in full.” (Emphasis ours.)
The chief fear at the Treasury and the Fed is “if Fannie and Freddie debt isn't repaid at 100% par, the Chinese may start dumping their hundreds of billions of Treasury securities, possibly causing a run on U.S. government debt and sharply raising Uncle Sam's borrowing costs,” Moore continued. And everyone else's borrowing costs he might have added. Overt selling of Treasury and Agency securities by foreign governments would send interest rates soaring within days, if not hours, once financial markets got wind of the sales.
Indeed, the amount of Agency debt held in custody by the Federal Reserve on behalf of foreign government owners has declined by $13 billion in the month since the bailout plan was approved after peaking at $986 billion the week of July 17 th, while foreign state holdings of Treasury debt has jumped $60 billion in the same time frame to a record $1.423 trillion.
And thus a conundrum. In the case of Fannie and Freddie, a bailout which keeps bondholders whole, at the expense of common and preferred shareholders, lends credence to those who believe we are capitulating to the wishes of foreign owners of Agency debt. If true, realistically, it now makes explicit a former implicit U.S. government guarantee of these obligations, making our total national debt now more like $15 trillion. More concernedly, if such tactics were successful, would we be at future risk for similar demands by our creditors?
On the other hand, if Agency bondholders (foreign and domestic) are given a “haircut,” in which bonds are redeemed by the Treasury at less than face value, say 90 cents on the dollar and, in essence, a partial default, would we then be provoking not only a sell-off of existing U.S. government debt – Treasuries and Agencies – but also be jeopardizing the sale of new debt, resulting in soaring interest rates and, for all intents and purposes, an economic disaster? And if preferred stockholders also take a hit and many of those securities are owned by other U.S. banks, attendant write downs could further weaken a fragile financial system.
With a fiscal 2008 budget deficit likely to exceed $400 billion and a fiscal 2009 budget deficit now estimated to approach $500 billion (net of Social Security surpluses of about $100 billion a year) we critically are dependent upon investor willingness to finance our shortfalls, and, as in the last decade, much of those bond purchases have come from overseas.
As an alternative, a more likely scenario now may be taking shape: the acquisition of Fannie and Freddie by a consortium of financial institutions, similar to how Long Term Capital Management was disposed of in 1998. Fannie and Freddie could be combined, then re-divided into a “good mortgage bank” and a “bad mortgage bank” (as in the Savings and Loan bailout). The good bank keeps the stuff worth holding, the 95% of performing mortgages, keeps the $50+ billion of preferred stock and junior securities (to keep U.S. banks whole) and the senior bonds, which would retain their implicit government guarantee, but common holders get thrown under the bus.
The “bad” bank gets saddled with $300 billion - $500 billion, or more, of dubious mortgage assets, acquired with newly issued Treasury debt (hence the necessary $800 billion increase to the national debt ceiling to $10.6 trillion) which get worked out over the next decade or so as economic conditions improve.
Some plan along these lines could appear in the next four-to-eight weeks. Messrs. Paulson and Bernanke will not allow Fannie and Freddie to fail, with the exception of common stockholders, as “failure is not an option.” They know the economic consequences of default are unthinkable.
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