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