Friday, August 8, 2008

Z Truth??

I am a conspiracy theorist. I don’t believe that Lee Harvey Oswald acted alone or the single pristine bullet theory, which authorities claim killed President Kennedy, wounded Governor Connally and appeared unscathed on a hospital gurney. I think that only one of those millions of UFO, Bigfoot, and Nessie sightings has to be true (in each genre) for there to be “something out there.”

So, here goes another one. Maybe this conspiracy has legs or maybe it’s bull pucky (which I hope) and I’ll merely entertain you with some fanciful thoughts. But, we have to start with a question.

Did the notorious Mr. Z hit the nail on the head?

Mr. Z’s Call

Mr. Z (my name for him), the knowledgeable Washington financial services expert, suggested to me—and likely others, the blabbermouth—that the Treasury’s announced plan to backstop the GSEs, “if” they ever needed help, really was part of a broader Paulson scheme to do away with those “damned GSEs” in their current structure.

Mr. Z speculated that the Treasury Secretary—who successfully sold his idea to the Congress—cunningly would employ his new authority to reduce the GSEs to a "government regulated utility" status, which the mortgage market still would heavily use, but which minimizes Fannie’s and Freddie’s overall financial risk as well as profit. The scheme would introduce some additional cost and inefficiency into the residential real estate market, but nobody would really question it or care, since so much else is going on with the economy and national politics.

The “Wise One” snarkily labeled the Paulson plan the “Gulf of Tonkin” resolution, analogous to what Congress passed when it used a questionable military incident in that puddle of water to give President Johnson the authority to declare war against North Vietnam.

This week, PIMCO’s Bill Gross suggested that both Fannie Mae and Freddie will be bailed out by Treasury within weeks. When the GSE bill was signed, a respected Washington journalist, who has covered GSE issues for years, confidently told me that she thinks that both companies would be “nationalized within a year.” Others have made similar calls and just in the past few days.

What do they know/see that I don’t??

Did Congress undertake the Vietnam War on a questionable pretext? Would Treasury use Freddie’s red ink or Fannie’s as justification to deconstruct and take over the GSEs?

Is Ben Bernanke’s middle name “Shalom?”

Paulson The Puppeteer

Hank Paulson isn’t the bad guy here, necessarily, merely the clever fellow who figured out how--possibly--to put this “disassembly” together, based on his understanding of markets, sense of politics, and insight into the amount of red ink facing Freddie and Fannie, and how those elements could be manipulated to produce an end to the modern GSEs.

It might never come to that, but signs are ominous.

Here’s how Paulson could roll up the GSEs with little or no complaints from their formerly adoring public, now reduced to a handful of scared shareholders, the immediate families of those remaining GSEs employees, not to mention the employees themselves, most foreign central banks holding a ton of GSE debt, and much of Wall Street which makes millions from the companies securities operations.

In the next month to three months, the Treasury Secretary would cite falling GSE capital (see Fannie’s numbers today, added to Freddie’s earlier this week) and escalating pending losses. He “insists” that the Treasury must come to the financial aid of Fannie Mae and/or Freddie Mac, by investing public money in their common or preferred stocks.

Who is going object and say “No?”

Will the companies balk, arguing that they still have sufficient capital to outlast the cascading red ink? Sure they will, but they have “negative credibility,” when they talk to the markets. Who will believe them? (If “neg-cred” ever makes it into the lexicon, I want credit for it!)

Will the GSEs go to court? I would if I was Fannie or Freddie. But wouldn’t the Secretary’s pronouncement and the resulting shareholder rush to sell underscore the very chaos Paulson says exists and requires his intervention? With the share price dropping to near zero, how would a court –in any timely fashion--differentiate between who caused what GSE problems and when? What judge rolls the Secretary of the Treasury and presumably the Fed, OFHEO, etc., when they concur that help is needed? And--what happens in the interim--until the Supreme Court is asked to get involved?

High stakes game, very high stakes game. But if a corporate putsch happens, I suspect that the market first erupts in anger and confusion, but then quickly settles down when Treasury guarantees GSE debt holders that they will be fine. Paulson et al win and the companies become government step-children.

Who Really Cares?

The “housers” might bitch and moan, but who listens to them these days? And, no matter what you think, the public—because it has no idea what is true and what isn’t and has no real idea from where mortgage money comes—likely has OD’d on the constant Fannie and Freddie soap operas.

Once under Treasury control, with no shareholder interests to bother them, Treasury uses up existing capital, starts to unwind the GSE portfolios which creates some more capital, and announces to the world that Fannie and Freddie will “stay in place,” as the nation’s secondary mortgage market pillars, but under Treasury/OFHEO (or its successor) control.

Some/many GSE employees will bolt, but others will hang around and get paid (less!) to do what the government wants.

Senators and Members of Congress, who will be back home seeking their own re-election or celebrating/lamenting the Obama win and the massive new Democrat majorities, will say much but do little.

President-to-be Obama might “harrumph” but then ask Paulson to hang around a bit until his own Treasury candidate can get his/her hands around the issue. But the world would move on.

Now, as I said, Mr. Z started me down this road. Rep. Henry Waxman’s recent request about possible Administration hanky panky in the stunning downturns in Fannie and Freddie stock prices caused me to wonder a bit about this White House, which consistently has used the media especially when the target was the GSEs, helping set a predicate for intervention.

Can The GSEs Avoid the Ax?

If these folks (Mr. Z, Congressman Waxman, Bill Gross, and others) are right, is there a way to avoid this takeover scenario? Is the end of GSEs, as we know them, inevitable?

“No,” it isn’t inevitable and “Yes” there is a way--albeit narrow--to avoid it.

The GSEs need to get their legal ducks in order today and plan what they would do, if Treasury tried a premature takeover, when capital still exists on their books. Get the lawyers working now, not after Treasury strikes.

And Fannie and Freddie, quickly, need to build their equity bases—with real capital—before they get close to the point where Paulson or others can argue they’re bankrupt. Move whatever has value, now. Shave whatever expenses you can, now. (Oh, and Fannie and Freddie should stop blaming the “housing mission” for the crap loans and the “Alt A” business decisions they made. That’s dishonest!)

The GSEs must then hope--if all of their amelioration efforts produce nothing--that the worst thing that happens to the companies is that Fannie and Freddie become clones of the gas and electric companies, regulated utilities with limited growth and earnings.

Maloni 8-8-2008


Anonymous said...

You say "Fannie and Freddie should stop blaming the 'housing mission' for the crap loans and the “Alt A” business decisions they made. That’s dishonest."

Can you explain your thinking? I agree that FNM management increasingly became captive to Countrywide and other major lenders and lost its "credit culture" as the bubble inflated. However, in my view, the Bush administration also pressured HUD to impose more and more aggressive housing goals, beyond all rationality. Instead of making a stand, FNM (especially after its financial "scandle") necessarily kept finding more and more risky ways to comply. And this effort helped produce a riskier book of business.

Anonymous said...

The ideological enemies of the GSEs would find a nationalized secondary market even more of an anathema. So, as I see it, they'd love to kill the GSEs, not take them over. And they can't kill the GSEs until there's a functioning private-sector alternative. Hence, the Treasury's effort to kickstart covered bonds on Wall Street. But, no private mortgage market can be created quickly enough to meet their immediate desire to finish off the GSEs. This leads me to the most likely scenario: A bailout will be delayed as long as possible, such as by reiterating the goverment's now-express guaranty and by contorting or not applying accounting rules. If a bailout is needed, the government will take its pound of flesh in terms of shareholder dilution, but leave the GSE structure in place. The realization of their desire to deliver a coup-de-grace to the GSEs will have to await another Republican administration.

Bill Maloni said...

I not sure if the same "Anonymous" posted both comments, but let me try to answer him/her on both counts.

Again, this is my opinion, but I think both companies made decisions, related more to profit and market share concerns than "mission issues," and acquired loans which historically they would not have bought, had not "private label" competition existed.

In Fannie's case, I think "Alt A" loans--which I don't think they would have purchased in the past--generated this line from their Second Quarter earnings statement.

"As of June 30, 2008, our Alt-A mortgage loans represented approximately 11 percent of our total mortgage book of business and 50 percent of our second quarter credit loss."

Now, to be totally fair to Fannie, they didn't pin their losses on housing goals mission, as my friend Dick Syron partly did when he was on CNBC, Tuesday, discussing Freddie's performance last quarter.

Second question.

The minute the government puts in one dime to either GSE, I think they are finished as privately owned and operated companies, which is why I have exhorted them to do anything possible to avoid that chance.

The mortgage market DOES need the Fannie/Freddie dedicated investor function, but it quickly could adapt--as I wrote this morning--to slightly higher prices and inefficiency if the GSEs were taken over and run by the government in some dilutive way.

In many ways, that is the ideal situation for the GSE enemies. F/F are there to take their mortgage risks but not so free to impose lower prices and standardization on their customers.

It won't be efficient if there is a takeover--which is why I hope it never happens--and the next step may be for Congress to recreate Fannie and Freddie calling them something else.

Sure it would be smarter, smoother, and better policy just to make sure the two stay alive, doing what they do now, and run as private companies, but angry or chagrined public officials and politicos often don't think that way--AND, in this view Fannie and Freddie, their employees and shareholders would get rewarded.

To repeat, that's why I want the companies--if they can--to save themselves!

Thanks for the comments/questions.

Anonymous said...


I learned of your blog when your last post was posted on Housing Doom.

To get more exposure, you should have your posts put on:


John M said...

Bill (and previous commenter) -

There are "tips" e-mail addresses at all the Implode-O-Meter sites so don't hesitate to send along a link to them if you feel any post is appropriate. They are always looking for good content for their stories lists.

This California law prof has (probably independently) taken up Roubini's suggestion to impose a haircut on agency debt holders. I shudder to think of the implications if this idea gains traction.

"Who pays when lenders fail? Fannie Mae and Freddie Mac investors should pony up too", by James P. Tuthill, San Francisco Chronicle, August 7, 2008.

Still, after this week it looks like the GSE world we have known is about over. Lots of problems left in the private-label world, though. What's going on with WaMu today with the stock price plunging on no news at all? FDIC will certainly be knocking on someone's door this afternoon, but surely not them!

Bill Maloni said...

The moment I sent the first response, I realized that "Anonymous" is available to anyone who comments.
Sop, I apologize to the "second" commenter if I lumped you together with somebody.

John, as HD has been writing for months, this is a calamitous "crap storm" and it's failing on everyone in the industry and some big players--and possibly the biggest, although I hope not--could tumble.

The NAR had some encouraging sales signals, yesterday, and the stock market this week had two wonderful days (plus one bad one), so there is a chance that a "bottom" is near.

I think Fannie is better able to handle the bad news than Freddie, but I don't know at what point Paulson et al decide to press the red button and declare them subject to "help!"

I sincerely hope that he waits and waits and waits some more.

People, today, are PO'd at the housing situation, they are PO'd at the GSEs; some are even PO'd on the idea of homeownership, all of which are typical reactions when something goes bad and public and media get into high dudgeon.

Fannie's and Freddie's problems--in my view--were not about what they were created to do, which I think they perform well--but decisions by company officials, who likely made mistakes.

There is a remedy for that and it's not doing away with the institutions, since their roles have been affirmed time and again, even in these lousy markets (see "jumbo illiquidity" and Admin calls in the past several weeks for the GSEs to stand up and do more).

76s said...

Thanks, Bill, for sharing more details on your nationalization thesis. I have a better understanding of your analysis.

I'd like to hear more of your thinking on the "end game." If the GSEs are nationalized, what's the likliest scenarion? Have the secondary market run like FHA/Ginnie Mae in perpetuity? If new Agencies are created, would they be GSEs or all public? Would the government keep the secondary market nationalized until Wall St has a functioning substitute and then let the goverment get out of the business? I can't see an IPO, can you? What did you make of the Housing Bill's change to the Board of Directors of each GSE (18>13 and no Presidential appointments)?

Bill Maloni said...

The problem in describing it is that we have no precedent or model.

Which is why, if Secretary Paulson pulls the trigger, he'll get the benefit of the doubt with whatever
scheme he proposes, since he'll argue that it is an "emergency" and he has the best perspective on what to do and as noted I am sure that the Fed and OFHEO will agree, leaving little room for alternatives, unless the GFSEs successfully get a court to intervene.

Th reason why I argue the government sponsored secondary mortgage market works is that nobody wants that job and nobody--without the GSE structure--
would stay in markets 24-7 in "good times and bad," UNLESS they had the protection (which still can go bad) of only originating and holding ARMs.

If our nation ever got weaned from preference for long term fixed rate financing, the situation which exists in most other modern countries, then some "private/private" investors might try and take on the F/F role, because the loan's structure gives them some interest rate protection, albeit no credit protection.

One other possibility--without the GSEs--is for non-GSE investors to charge a huge premium for FRMs to cover them when default threatens.

Right now, because of F/F, we have both plentiful long term fixed rate financing and costs that reasonably reflect the risks (although both investors have been increasing them to cover their burgeoning red ink).

I think the advantages of a privately owned F/F outweigh whatever disadvantages one sees, which is why I think if the GSEs ever are cashiered, the Congress eventually would recreate them, after going through some hiatus with hybrids and stop and go mortgage financing.

If you had a giant FHA, with authority to help everyone, the lenders and others would rip it off left and right, just as they did in the 60's and 70's. But, for some not me, that may be a preferable mortgage market model. not me.

The banks showed themselves wanting when "jumbo illiquidity" was rampant. They weren't challenged by any GSE competitors but refused to step up or tried to overcharge when they did so.

Making the GSEs regulated utilities implies having them perform but removing much of the market forces and incentives which drove them traditionally. But, the more the government touches something the worse it performs.

So, I'll leave it to you, what is the best option is there is no F/f??

Mine is to keep what we have.