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Fannie Mae and Freddie Mac Have Been Taken Over By The Treasury: Analysis of the Press Release

Conflict Between Public and Private Roles

At 11AM Eastern Time on Sunday, September 07, 2008, the Treasury Department released the text of a joint statement regarding the GSEs, Fannie Mae and Freddie Mac.

The statement contains remarks by Treasury Secretary Henry Paulson, and Director James Lockhart of the newly-chartered Federal Housing Finance Agency. (The FHFA now has regulatory oversight over the GSEs.)

As expected, the GSEs will enter government conservatorship (which is not the same as receivership). Several additional steps have been announced as well, and some new text regarding these additional actions was released as well.

You can read the Paulson/Lockhart statement here. Read on for commentary on specific points in the statement. As soon as I can, I’ll give you commentary on the other parts of the release, relating to the specific actions being taken.

The timing of this release was a little surprising given the recent history of emergency Fed/Treasury actions. But on reflection, this announcement is not an emergency response requiring round-the-clock action over a weekend, and completion by the time Asian markets open for Monday trading, which happens on Sunday evening on the East Coast.

These are steps that have been debated intensely over the last several weeks, and were taken in a somewhat calmer context than either the Bear Stearns rescue in March or the Fannie/Freddie mini-blowup in late July.

They are also steps that were enabled by the temporary emergency powers inserted at Paulson’s behest in Housing and Economic Recovery Act (aka, the Countrywide Bailout Bill), signed into law by President Bush five weeks ago. Much of what is being announced today will expire with the temporary emergency authorities in December 2009.

The statement notes in a very brief sentence the three goals of the takeover of Fannie and Freddie: market stability, mortgage availability, and taxpayer protection.

What a small number of simple words to capture an incredibly large conundrum! Because these three goals are all in direct tension with each other. Just about anything you might logically consider doing to address one of the three, is going to work against the other two.

What Treasury is doing by jumping out in front of this non-emergency situation, is to get control over it before it catches fire and starts burning up everything around it. By doing it now, they have an expanded menu of options. As you’ll see when we go through this, the goal that they were by far the most concerned with is market stability.

On to the controversy over whether the government should be taking over what after all are private organizations, with common and preferred shareholders.

Paulson and Lockhart correctly note at several points that there is and always has been a fundamental conflict embedded in the very structure of the GSEs. (Fannie Mae was a New Deal program, and Freddie Mac was part of the Great Society.)

The conflict is between the private objectives and the public mission of the GSEs. They’re investor-owned entities like any other, which means their directors and managements must seek to increase the value of their stock by whatever legal means are available.

But at the same time, Congress has given Fannie and Freddie the responsibility to support the expansion of home ownership by Americans. This split personality is what has allowed these entities to get so incredibly big on a tiny sliver of regulatory capital, and to largely escape the market discipline that keeps truly-private companies in line.

And so we’ve come to a pass where too much of the global financial system is threatened by the instability of Fannie and Freddie, and the Treasury is using its emergency powers to keep them from collapsing, buying time for Congress to resolve the conflict by way of actual policy making.

And of course, there is a fundamental question about this: should the housing market be directly supported by taxpayers? If you’re a free-market conservative, the answer is HELL NO. If you’re a progressive, the answer is OH YES. If you’re a politician of either party, the answer depends on who gave you your last big campaign contribution. This is the policy debate that we’ll be having next year, and today’s Treasury action explicitly stops short of resolving the issue.

Ok, on to specifics.

Fannie and Freddie will enter what is called “conservatorship.” Their existing senior management and directors will be replaced (including Fannie CEO Dan Mudd and Freddie CEO Dick Syron).

But the existing common and preferred shareholders will remain in place, with an important change. Business will proceed almost exactly as usual tomorrow morning, and that was a key goal.

The big problem that Treasury is trying to address is the capital adequacy of Fannie and Freddie. Because they have suffered large losses in their mortgage portfolios, and expect more of the same, their so-called regulatory capital has been nearly depleted.

Today’s report makes no mention of the fact that both Fannie and Freddie have engaged in some shenanigans recently to make their capital positions look less bad. Their CEOs are being fired summarily for this.

If we were in China, they’d probably have “committed suicide” with bullets inexplicably entering the backs of their heads. I’d certainly want to shoot them if I were a shareholder of either GSE. There are some things the Chinese do better than we do.

The Treasury has executed a Preferred Stock Purchase Agreement with the GSEs, which I’ll analyze specifically in another post. In short, the Treasury has the right to purchase shares of a new class of stock that is senior to all the existing common and preferred shares. The stated goal is to ensure that both GSEs have a positive net worth at all times.

Remember that portfolio losses are borne first by common shareholders, then by preferred shareholders, and only then by subordinated and senior debtholders. By interposing a new class of senior equity between the existing shares and the debt, the Treasury has guaranteed that holders of agency paper (including subordinated paper) will not take any losses.

Who takes the losses instead? US taxpayers. I’ll give you a minute to get the anger out of your system. Go break a few windows if you have to.

Feeling a little better? Ok, let’s keep going. Why the %^&#%&*$% would Treasury do this? Because of their first goal, which is market stability.

There is about $5 trillion worth of agency paper outstanding. About $1.6 trillion is directly issued by the GSEs and the rest is guaranteed by them. The constellation of people that hold this paper includes nearly every major investor in the world, including most of the world’s central banks and sovereign wealth funds. Our own Federal Reserve now holds about $400 billion worth of the stuff. The People’s Bank of China (such an ironic name) has maybe $1.1 trillion.

Even a slight impairment in the value of this paper would have seriously threatened the value of the dollar and the stability of the global financial system. Treasury really had no choice.

What about the stockholders? What will happen to them is best described by a technical Wall Street term that unfortunately violates the posting rules of this site. Suffice to say that the term denotes the forceful insertion of a long, pointed object into one’s anus.

How much are we talking about here? Well, a quick look at Fannie and Freddie’s balance sheets shows shareholder equity of about $70 billion. The market value of the common is now $15 billion. There is about $30 billion in existing preferred equity, give or take, most of it held by banks. Today’s report coyly notes that most of this equity does not form an appreciable proportion of the capital of the institutions that hold it. Translated, that means: ”Game over. You lose.”

Ok, two more things, then I’ll stop for now.

There will be a secured lending facility extended to the GSEs. But they already have one, and have had for decades. No details on whether this is an expansion of the existing line, or something new and different.

Finally, and this is interesting, Treasury will be purchasing some agency mortgage-backed securities. This gets us into one of their other goals, the promotion of new mortgages. The government is explicitly going to be bidding for agency paper, with the goal of putting a floor under this market. That (theoretically) will make it easier for the world’s investors to keep funding US mortgage origination. This is worth a full post all by itself.

Whew. That’s a long post. I’m glad you got to the end of it. I’ll have more analysis and market reactions as the next few days unfold.

-Francis Cianfrocca

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