GSEs: Too many powers: Part 3, the bus catches you
[Continued from the preceding Part 1 and Part 2]
Continuing our analysis of the GSEs’ takeover by Treasury’s conservatorship, using as our principal text a lengthy if jumbled New York Times account, we’ve now reached the crunch-time weekend when Treasury had concluded something had to be done – and fast:
How many minutes ’til takeover?
While Democrats gathered in Denver to nominate Senator Barack Obama two weeks ago and Republicans met last week in St. Paul to nominate Senator John McCain, Mr. Paulson and his top aides worked nonstop — often for 18 hours a day, including Labor Day weekend — to scrutinize possibilities and complete the details of a government takeover of both companies.
Takeover had become inescapable, at least in Secretary Paulson’s mind, because markets were moving even as government did not, and the votes were unanimously of no confidence:
His strategy did not anticipate that investors, already spooked by a year of troubles in the financial markets, might panic any time that rumors of problems at Fannie and Freddie cropped up.
Panic it was, panic driven by fear of the unknown and unbindable sovereign.
You think me mysterious?
A panic among equity shareholders alone wouldn’t necessarily matter, but two other possibilities would matter: (a) if the equity fear led to erosion in confidence in GSE debt securities, triggering runaway spread-widening, or (b) if the companies in fact suffered meaningful writedowns, and were forced to raise capital at the worst possible time.
Freddie Mac had the second problem:
Freddie, in particular, was in a bind. Unlike Fannie, it had not raised capital earlier, when markets were less nervous. Mr. Syron figured that the company had one final chance to raise money and signal to debt investors that the company was viable.
By late August, both companies also had the first problem, as fear had infected the debt markets:
Most worrisome, the companies’ cost of borrowing was growing more expensive, and central banks in Asia and
If we’ve taken any lessons from the Great Depression, the first and most valuable is that in times of credit stress, capital runs for the sidelines, and that’s the worst possible thing for the markets. When a crunch happens, maintaining liquidity is essential, and since global liquidity is beyond the direct control of any sovereign (who isn’t willing to trigger hyperinflation by simply printing wheelbarrows full of money), you can assure ongoing liquidity in rickety institutions only by putting the nation’s “full faith and credit” behind them.
Morgan Stanley assigned teams of financial analysts in the
I can’t verify this figure. Probably nobody who isn’t sworn to secrecy could. Maybe it’ll prove to be vastly overstated – for all our sakes, let’s hope so.
But, in a panic environment, reality doesn’t matter. Shouting “fifty bill” in a crowded equity market would have triggered a Cocoanut-Grove-like stampede out of the GSEs, not just their equity but their debt.
Hundreds died …
… because panic jammed the revolving doors
Throughout August, telephone conferences between officials and advisers often began at 7:30 in the morning and lasted until 11 at night. Mr. Paulson started telling friends that after winning authority to intervene, he “felt like a dog who’d caught the bus and didn’t know what to do with it.”
Secretary Paulson had too many powers – so many that he was going to be forced to use some.
You won’t like me when I’m angry
In Shooting an Elephant, George Orwell’s wondrously unaffected prose describes the nature of having unlimited sovereign power, even if one is only a minor colonial official in
One day something happened which in a roundabout way was enlightening. It was a tiny incident in itself, but it gave me a better glimpse than I had had before of the … real motives for which … governments act.
[Essay follows]
Afterwards, of course, there were endless discussions about the shooting of the elephant. The owner was furious, but he was only an Indian and could do nothing. Besides, legally I had done the right thing, for a mad elephant has to be killed, like a mad dog, if its owner fails to control it. Among the Europeans opinion was divided. The older men said I was right, the younger men said it was a damn shame to shoot an elephant for killing a coolie, because an elephant was worth more than any damn Coringhee coolie. And afterwards I was very glad that the coolie had been killed; it put me legally in the right and it gave me a sufficient pretext for shooting the elephant. I often wondered whether any of the others grasped that I had done it solely to avoid looking a fool.
As usual with Orwell, he plays himself as the meek fool, and yet as I wrote this post, I thought of Secretary Paulson, most certainly no fool and no financial coward, finding himself pressed in to shooting the GSE elephants because the global financial markets were demanding he do so. In Orwell’s Burmese experience, I find modern financial echoes – furious owners (shareholders), an elephant out of control (GSE borrowing costs), and innocent bystanders (new homeowners) hurt. Like Orwell, the secretary sought the least-painful execution:
As possibilities were debated, Treasury officials eventually concluded that if they had to act, the best choice was a conservatorship — a takeover that would make government backing of the companies’ debts and obligations explicit but would remove the companies’ leadership while still keeping them operating.
Conservatorship is like a Chapter 11 reorganization, giving an entity the opportunity rearrange its debts. Most companies emerge from Chapter 11 reconstituted and viable.
“They called it ‘sticking the companies in a timeout,’ ” said one person with firsthand knowledge of the conversations. “It protects the safety and soundness of the economy but also gives everyone breathing space.”
Safety of the economy? That’s in my interest as a taxpayer, and the world’s interest as stakeholders in the global financial markets, but at the expense of Fannie/ Freddie’s common stockholders. We’ll return to this.
Mindful of the high stakes, Mr. Paulson convened a secure video teleconference on Aug. 26 from a bunker under the West Wing of the White House to brief President Bush, who was at his ranch in
Yes, Mr. President, that many zeroes
On that long weekend, things got down to the short strokes:
The next day, Mr. Paulson called Mr. Syron and Mr. Mudd to separate meetings at the offices of Mr. Lockhart without saying why. Freddie was still looking for fresh capital and interviewing people for senior positions.
“I think things are looking up, e’re going to talk to Treasury this weekend”
But in his meetings, Mr. Paulson said he intended to put both companies into conservatorship. As part of that plan, Mr. Syron and Mr. Mudd would both be required to step down.
That can’t have been a pleasant conversation – and it has its ironic sidelight:
Mr. Mudd pleaded with Mr. Paulson to spare Fannie Mae, people with knowledge of the meeting said. He said that he abided last spring with regulators’ demands to raise more capital, adding that the company was in better financial health than Freddie.
Mr. Mudd is right on both counts – which makes Secretary Paulson’s response all the more revealing:
Mr. Paulson responded that Freddie was nearing a crisis and that, in the eyes of the markets, the companies were joined at the hip. He would not treat them differently for fear that similar problems, over time, would engulf Fannie Mae, but that time closer to the election. Mr. Paulson told both companies that they had no choice.
Gentlemen, you live by the duopoly, you die by the duopoly.
Putting both companies into conservatorship signals motives beyond the purely financial – and that’s very worth understanding.
President Bush returned from
Chapter 11 bankruptcy is an action taken to protect unsecured creditors and common stockholders. Conservatorship of the GSEs had neither motive in mind – indeed, as takeover rumors swirled that weekend, the companies’ share prices plunged 90%. Rather, it was done for policy motives. Such a large share of US mortgage financing passes through the GSEs – something like four out of every five new mortgages – that they have virtual duopoly power over access to mortgage finance. Never mind that nationally, we should not have allowed ourselves to be put in this position; life is full of should-haves.
Maybe I should ask for fewer powers?
Conservatorship wasn’t a corporate-financial move, it was a national-policy move.
On Sunday, with the president’s blessing, Mr. Paulson announced the solution: a takeover that could turn into the biggest and costliest government bailout ever of private companies.
Sure, that’s what it could turn into. Or it could turn out not to cost the taxpayers a dime – indeed, with the preferred stock, they taxpayers stand to make money if things go well. (That’s what happened with the Chrysler loan guarantees thirty years ago; Treasury made good money.)
“Today’s necessary but likely very expensive action for taxpayers is the consequence of regulatory neglect and of a broader political system’s reluctance to take on what should have been clearly seen as festering problems,” said Lawrence H. Summers, who as Treasury secretary under President Bill Clinton had warned of mounting problems at the companies.
Warned? Not loudly enough, and not forcefully enough – during that administration, GSE reform was never a political priority. (Trust me, I’ve been listening.) No one moved against Fannie/ Freddie when they were high on the hog.
We just kept printing securities
After briefing the president, the Treasury moved quickly. Over Labor Day weekend, Mr. Paulson convened meetings with Ben S. Bernanke, chairman of the Federal Reserve; Kevin Warsh, a Fed governor; and Mr. Lockhart, Fannie and Freddie’s regulator.
GSE securities, particularly, Fannie Mae’s, are bought all around the world. Even as Secretary Paulson’s actions may well have saved the country’s and the globe’s financial system, they have also destroyed, at least temporarily, a massive amount of Fannie/ Freddie shareholder value.
In moving against the companies, Treasury has elected to inflict major collateral damage on the common shareholders so as to protect everybody else.
As I’ve often quoted Spiderman’s Uncle Ben: “With great power comes great responsibility.”
Be careful you don’t get stuck with that sticky stuff
By its actions ye shall know it, and Treasury has now moved twice.
1. Treasury arranged the shotgun marriage of Bear Stearns to JP Morgan Chase, and backstopped it by banking on value, an action that I applauded then and now.
2. Treasury took over the GSEs, an action that many of us, including me, thought unthinkable.
In March, Treasury started chasing the bus. In July, Treasury caught the bus. Now the bus has caught Treasury, as every large financial institution whose situation becomes precarious will now turn to the omnipotent Treasury secretary.
As I write this, Secretary Paulson has adamantly drawn his line in the sand:
Paulson’s public insistence that taxpayer funds will not be used to bail out Lehman, as they were earlier this year to facilitate the bailout of Bear Stearns by JP Morgan Chase, makes such help unlikely.
On Monday, we saw the consequences: Lehman filed for Chapter 11 bankruptcy.
Should never have got so extended
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