Friday, September 05, 2008

GSE Bailout: Episode III

In recent weeks, a GSE bailout has seemed less imminent. Not because anything is getting better, but because it appears that the Treasury lacks the will to make a move. To be fair, the way the authorizing legislation is written, the Treasury cannot make a move without either the GSEs falling below their capital minimums or compliance by the companies. Based solely on how the company's are valuing their assets and liabilities, their capital position is well above regulatory minimums (especially Fannie Mae).

Now many believe that F&F's asset values are inflated, and perhaps that's true. But what do we expect? Will the government come in and audit the companies, write down their assets and then nationalize? It seems far fetched.

So if there is going to be some near-term action on strengthening the GSEs, it will have to come in a form to which the companies would consent. Ergo, it can't be something that would punish common shareholders.

I think that leaves three options. First would be to do nothing and see how things develop. Let's get back to that one later. Second would be for the Treasury to start buying loans and/or securities from the GSEs to reduce their liabilities. I talked about how this could work here.

Third would be for the Treasury to help the GSEs raise private capital. What if the Treasury agreed to guaranty the principal (not the interest) on a preferred stock offering. The size would be whatever is determined to be needed. In reality it might not be a single preferred offering, but a series of offerings with some pre-determined limit as to the total size.

The preferreds would be callable after 5 years, with the call becoming automatic if the GSEs share price reaches some milestone. The idea would be that if the GSEs are able to issue common equity, then they would be forced to call the tax-payer backed preferred and issue their own securities of some variety.

The Treasury could charge some fee in exchange for the guaranty. Say its an interest rate equal to the 30-year Treasury bond rate, currently about 4.25%. What interest rate the preferred would carry to investors would be determined in the market, but I'd bet somewhere in the 6-7% area.

Here are the advantages of such a plan. First, it could be implemented right away, allowing for stability in the mortgage market and likely a decline in mortgage lending rates. Second, its probably a cheaper plan for tax payers when compared with other options. We know that F&F's new business will be profitable, so if they can be stabilized with a capital injection, the odds that tax payers actually have to shell out any cash is low.

Unfortunately, this kind of solution has a number of problems. First, it creates all kinds of moral hazard, as common equity holders wind up benefiting from the tax payers risk. Currently Fannie Mae and Freddie Mac preferreds are trading with 15% yields, and a new issue, if possible at all, would certainly come at a discount to current levels. So under this plan, the GSEs would be able to issue preferred equity about 500bps cheaper than would otherwise be.

Second, this plan doesn't move us any closer to a more permanent solution to the problem of macro risk and the GSEs. Its a plan that, while easy, doesn't really get us anywhere in the long-term. I suppose such a plan could be an interim step on the path toward full privatization, the idea being to stabilize the market now, buying time for a long-term solution.

Its looking to me like this administration won't do anything about Fannie Mae and Freddie Mac unless they are truly forced to do so. The closer we get to a new administration, the more likely that Paulson waits and lets the next Treasury secretary make the call on the GSEs. So I think we're in for another 6-months of the same with the GSEs. Its always possible that something happens in the interim that diminishes risk aversion and subsequently allows the GSEs to raise capital privately, but I'm not optimistic.

Would I buy agency securities given this outlook? Yes. Senior debt and MBS, but I remain underweight both. I'm probably negatively exposed should a full-on bailout occur. But that's a risk I'm willing to take.

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