The Plan for GSEs

The Federal Housing Finance Agency (FHFA), the regulator of the GSEs (Fannie Mae and Freddie Mac) announced today that it is putting these two behemoths into conservatorship. I have read through the announcement from Treasury Secretary Paulson and the statement made by James Lockhart, both of which are available at the Treasury Press Room online. (Please note that any quotes in this article not otherwise noted refer to this release.) There are some interesting aspects to this plan, as well as interesting questions.

The first question is why. Why put these entities into conservatorship now? According to today’s statements, the root cause of the problem is the inherent conflict within these organizations of being run for profit but with a purpose of serving a public interest. Of course, these institutions have existed in this form for quite some time (1968 for Fannie Mae and 1970 for Freddie Mac), so this would not be why they are being put into conservatorship now. They are being put into conservatorship now because they are no longer able to accomplish their mission of helping to provide liquidity to the mortgage market and “respond appropriately to the private capital market,” (see the legislation that created Freddie Mac here) and they are at risk of failure which could have devastating ripple effects in the financial industry and the broader economy. Mismanagement, excessive lobbying success, and the rapid decline in home prices have left them inadequately capitalized to carry out their missions.

Because they are undercapitalized investors have not been snapping up GSE liabilities. The poor demand for their debt results in the GSEs paying higher interest on borrowings, and this translates into more expensive mortgages for borrowers. So, even though the Federal Reserve has the target Federal Funds rate down to 2%, a negative real rate, interest rates in the mortgage markets are going up. Some believe this situation goes well beyond the GSEs and is a reflection of the entire financial system in the United States, but don’t expect to hear any politician or regulator tell you that in public. A Heard On The Street Column in The Wall Street Journal Online Edition makes that point this morning.

In order to provide liquidity to the mortgage market (which means demand for mortgage backed securities and debt issued by the GSEs), the Federal Government has decided to step in with a four-point plan. The hope is that if this plan is successful, mortgage interest rates will decline causing increased housing demand softening the housing price declines we are seeing. In turn, this should speed a recovery in the overall economy as falling home prices represent a huge drag on consumer spending. In addition, the systemic risk from a failure of the GSEs goes away (is transferred to the United States taxpayer).

One point I want to mention before getting into the details of how the plan works is that according to the statement released by James Lockhart, “all political activities – including all lobbying – will be halted immediately.” I find this ironic, and I would like to know when this rule would be applied to Wall Street.

That’s the why, now to the how. Step one is placing the GSEs into conservatorship, meaning they will now be run by FHFA. Investors who own stock lose all of their rights although they can keep the stock in the hope that at the end of all of this there will be some value in it. There will be no dividends paid to common or preferred shareholders. There is a ripple effect to this part of the plan, as any financial institution that holds a large amount of stock in the GSEs will likely realize a sudden and dramatic loss. The agencies involved in the financial system

encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares … are likely to reduce their regulatory capital below ‘well capitalized.’ The banking agencies are prepared to work with the affected institutions….

In any event, the largest players in the mortgage markets are now in the hands of regulators.

Treasury announced an additional three steps it will take to shore up confidence in the GSEs so their debt costs will come down and to provide liquidity to the mortgage market. These are (i) taxpayer guarantees of GSE debt backed by taxpayer purchases of Senior Preferred Stock of the GSEs as required (initially up to $100 billion for each GSE), (ii) “market” purchases of GSE mortgage backed securities (MBS) in an unspecified amount, and (iii) a taxpayer credit line of an unspecified amount for loans to the GSEs and the Federal Home Loan Banks secured by GSE MBS (or, in the case of the Federal Home Loan Banks, advances). These steps are all in addition to the $400 billion of liquidity provided by the Federal Reserve, the recent $300 billion taxpayer guaranteed FHA refinance plan, and the $250 billion of taxpayer guaranteed debt issued by the Federal Home Loan Banks since this “contained” “subprime” mortgage crisis began.

First, the Treasury (that would be the taxpayers) has guaranteed the solvency of the GSEs. So, if these entities lose money and become insolvent, the United States taxpayer will purchase up to $100 billion of Senior Preferred Stock in each entity that will be senior to existing preferred stock and common stock outstanding. This amount is not necessarily a limit on what taxpayers will invest – rather it is an amount chosen by Treasury as an initial facility size. Just to put this amount into perspective, the current common equity of Freddie Mac is approximately $12 billion. This taxpayer investment program is aimed at shoring up demand for GSE debt in the hope it will reduce the cost of debt and, in turn, bring down mortgage interest rates. In order to protect taxpayers, Treasury also gets warrants to purchase, at a “nominal” cost, up to 79.9% of each GSE. Senior and subordinated debt issued by the GSEs and the MBS they issue and guarantee remain senior to taxpayers and are, in fact, guaranteed by taxpayers because if the GSE can’t pay them taxpayers purchase more Senior Preferred Stock to provide the funds. The total amount of this debt is massive, but these are backed by mortgages and so losses are what we should be focused on. Even so, we are talking about a total principal exposure of over $5 trillion dollars.

As part of the agreement between Treasury and the GSEs, each GSE must shrink its on-balance sheet mortgage assets by 10% per year from $850 billion (a little more than what they are today) on December 31, 2009 to $250 billion. The impact of such a reduction in size on the GSEs’ ability to act as a conduit between lenders and the secondary market is likely to be substantial. According to FHFA this should address the systemic risk posed by the size of these institutions. It seems a shame, however, that publicly assisted housing finance that had worked so well until a few years ago is being forced to all but disappear. The ultimate losers would be the general public and the ultimate winners – well – whoever will satisfy all the mortgage demand when the GSEs are too small. Hopefully Congress will figure out a way to preserve the public benefit (Representative Frank?).

The second step Treasury is taking is initiating a program of purchasing GSE MBS that are credit guaranteed by the GSEs. Now remember that pursuant to the step just discussed these guarantees are now guarantees of the Treasury. Yes, the taxpayers will be purchasing taxpayer guaranteed debt with taxpayer funds. This part of the plan hopes to provide additional liquidity to the market for mortgage backed securities – something that the $400 billion or so that the Federal Reserve has provided, plus the $250 billion or so the Federal Home Loan Banks have provided, plus the $300 billion FHA plan, have not accomplished. Treasury will designate “independent asset managers as financial agents” to make purchases of mortgage backed securities on behalf of Treasury. Of course, none of these people know one another so we can rest assured that there will be no favoritism regarding who Treasury purchases the GSE MBS from (hummm). Two glaring mysteries in this part of the plan – how much will taxpayers purchase and from who?

Finally, Treasury is providing a collateralized loan facility to the GSEs AND the Federal Home Loan Banks. So, if the market for GSE debt is unfavorable even after all of the other steps, taxpayers will lend the money to the GSEs taking MBS as collateral, and if the Federal Home Loan Banks run into problems issuing their taxpayer guaranteed debt they too can borrow from the taxpayers directly (this type of borrowing would fund advances at these banks that are collateralized by mortgage assets of financial institutions). These lines of credit are available until December 31, 2009, as authorized by the recent legislation passed by Congress. There is no stated limit on the overall size of this facility.

If you are interested in following your money Treasury will be releasing information on borrowing by the GSEs and Federal Home Loan Banks in the Daily Treasury Statement. Purchases of MBS will be reported monthly in the Monthly Treasury Statement.

All of this raises some very interesting questions about our overall economic system. If time permits I will publish a perspective on possible root causes of all of these deviations from our “free market” system.

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