GSEs: Too many powers: Part 2, catching the bus
[Continued from yesterday’s Part 1.]
Yesterday’s chronicle of the GSEs’ takeover by Treasury’s conservatorship, using as our principal text a lengthy if jumbled New York Times account, had reached the point of the landmark legislation that Treasury Secretary Henry Paulson thought – and for that matter, I thought – would clearly signal to the marketplace that the GSEs were going to be survivors, and hence would calm the troubled waters.
Like a bridge over troubled water/
I will fund your loans
When the legislation passes, I postulated:
Peekaboo is over. The Federal guarantee has been chased out of hiding: the GSEs are too big to fail, and we’re going to protect them if we have to.
Any doubts?
Fannie Mae and Freddie Mac, which each have a $2.25 billion line of credit with the Treasury, would see their current government loan limit raised until January 2009.
If the companies’ financial condition were to reach a crisis, Treasury could take an equity stake in either company. That power, too, would expire in January 2009.
Time will tell what this costs the taxpayers:
* There is a better-than-even chance that the emergency measures will not be needed, meaning there will be no cost to taxpayers. If the lifeline is required, the Congressional Budget Office said, there is a 5 percent chance that the companies may need $100 billion but more likely would need $25 billion.
Personally, I bet it’s zero – just like the Chrysler loan guarantee of nearly thirty years ago – which was a similar case of the government backstopping with credit an entity with long-term viability but short-term balance sheet weakness.
The role of protector will be played by a new entity, the Federal Housing Finance Agency (FHFA), who’s going to have substantial new powers that it will deploy as permanently advised by the Federal Reserve Board.
I just offer advice … oh, and money, too
This means an end to OFHEO, the Office of Federal Housing Enterprise Oversight, which did yeoman service despite being both legally toothless and pilloried by the GSEs.
The capital markets had been spooked because the Federal guarantee, long presumed to exist, was being called into question. It’s hard to blame Secretary Paulson (the man whose signature is on the money we print) for thinking that, having done precisely what the markets wanted him to do – make manifest the Federal commitment to GSE safety and soundness, and pledge the Federal checkbook in their defense – he expected the pledge to be enough.
When your signature’s on the money, isn’t that enough?
At the time, Mr. Paulson said he hoped never to use the authority. “If you’ve got a bazooka and people know you’ve got it, you may not have to take it out,” he told one Congressional panel.
But in early July, as the housing crisis continued to widen and deepen, confidence in the companies began to evaporate. Rumors spread that Fannie and Freddie were not fully reflecting losses from rising foreclosures on mortgages they held.
Here’s something I missed – that global investors, people who routinely move 1,000,000,000’s of dollars, were getting panicky. (I’ve written about this recently in The pile-up in slow motion, about which I’ll be posting later.)
The stocks of both companies fell more than 60 percent during the second week of July, to single-digit prices, and the cost of borrowing money rose for both, reflecting anxiety over growing risk. Alarmed, Mr. Paulson asked Congress to give him the authority to rescue the companies if necessary. Congress quickly granted him that power.
The problem, I now see, is that if you just read the statute’s plain language, the powers granted Treasury under HERA are so sweeping they amount to a financial dictatorship.
I’m from the Treasury and I’m here to help you
These powers are so extensive that, with a bit of ingenuity, I’m confident they could be used to raise or lower the price of value or more or less any category of Fannie/ Freddie securities – debt in any tranche, or the flavors of equity. In other words, Treasury now controlled the price of every slice of GSE capitalization.
As bankers and traders around the world read the legislation, they asked themselves, How will so much power be used?
That’s for me to know and you to find out
To me it was and is self-evident the power would be handled responsibly, and benignly. Like the optimist I am, I was confident all would be well. Both companies had adequate capital, and weren’t short of cash. True, they had gargantuan loan rollovers looming, where it would be essential for somebody to step up and buy their securities. But I figured the easiest intervention would be for Treasury to buy GSE securities as needed to prevent their spreads from widening too much, in exactly the same way a central bank will intervene at the margin to prevent a currency from precipitously appreciating or depreciating.
If Freddie’s and Fannie’s problems worsened, a crisis of confidence could spread through the worldwide financial system, deepening the difficulties in the housing market and further weakening the economy — in the midst of a hard-fought presidential campaign.
(Ignore the Times’ throwaway imputation of political motives in the presidential campaign. That’s utter nonsense. We are talking about the global economy and financial system, and steps whose taking or not could decide between worldwide prosperity and worldwide depression.)
That was the obvious controllable safety valve, the one that could be dialed up or down as required, without disturbing the GSEs’ capital structure.
“First, do no financial harm”? Hmm …
Hence, I figured, as long as GSE debt securities didn’t rise too much in yield, there would be no need for Treasury to act, and things would settle down.
There was a risk—that the GSEs were carrying vast undisclosed writedowns in their loan books, writedowns that would drain their capital below minimum sufficiency levels. That worried Secretary Paulson too:
In late July, he called John J. Mack, the head of the investment bank Morgan Stanley, and asked his firm to consider advising the Treasury. Within the agency, Mr. Paulson told his deputies to start examining contingency plans.
As those discussions progressed, a mantra emerged among top officials, people with knowledge of the Treasury’s conversations said. The government’s priorities were to maximize (1) market stability, (2) mortgage affordability and (3) taxpayer protection.
That’s receivership thinking – not inappropriate, I hasten to add, but bankruptcy-think.
Mr. Paulson added a mantra of his own: he privately said he didn’t want to “kick the can down the road” and leave the problems for a future administration and Congress to solve.
Systemic risk as far as the eye can see?
August came and went. The GSEs sold securities. Behind-the-scenes pressure was applied to Freddie Mac to raise its capital.
For Freddie Mac, the beleaguered mortgage finance giant that was desperately trying to avoid a government takeover, the moment of truth came three weeks ago. [Roughly August 20 – Ed.]
In a last-ditch effort to raise money to offset billions of dollars of losses, Freddie’s chief executive, Richard F. Syron, traveled to
Over a couple of days, he and his lieutenants made their pitch — only to have every option rejected, people briefed on the discussions said.
Don’t like that idea either
Coincidentally, during the period when Freddie Mac’s fate was being sealed, I was writing a three-part blog post about Manny Ramirez’s contract, entitled When options have negative value, which included this line:
Don’t negotiate for things you will never use. You cannot renounce them, so you have to trade them away, and if you have nothing to trade for, the counterparty can actually hold you hostage.
That’s the danger inherent in having so many broad powers: people are afraid you’ll use them for your own purposes. In wargaming – especially of the cold-war variety – an essential principle is this: Always assume the enemy will use every weapon it has.
However, when he went to
You wan me do derminate dem?
Ever since banking was invented in the Renaissance, markets have struggled with the unsolvable problem of binding the sovereign – and the capital markets were telling Freddie Mac, in no uncertain terms, that it was no longer the master of its own fate, but vassal of a sovereign Treasury whose motives were unknown.
During the mid-seventeenth-century, Louis XIV (the Sun King) had as his financial secretary the genius Nicholas Fouquet.
His family motto was Quo non ascendant, “what heights will be not scale?”
After
Fouquet completed Vaux in 1661 and on 17 August, 1661, proudly showed it to his monarch at a luxurious feast. The story goes that the king, upon seeing Vaux’s splendors and realizing just how much must have been skimmed to make it possible, turned to his minister and thanked him for the magnificent gift he had just made of this palace to his King. As Voltaire summed it up:
“On 17 August, at six in the evening Fouquet was the King of France: at two in the morning he was nobody.”
Freddie Mac’s CEO, Richard Syron, and through him Secretary Paulson, had found out the hard way that a sovereign can have too many powers, because the multiplicity of choices makes almost any capital-damaging scenario both possible and indefensible.
You cannot hedge sovereign risk, and now the GSEs were entirely dependent on sovereign favor.
I’ve got their jewels in the palm of my hand
Mr. Syron told Mr. Paulson that efforts to raise money had been fruitless, prompting the Treasury secretary to set up the Aug. 26 video conference call with the president.
From implausible, sovereign rescue had become inescapable.
You see that logo, boys?
[Concluded tomorrow in Part 3.]
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