The Paulson doctrine(s): Part 2, as little as possible, if that
[Continued from yesterday's Part 1.]
In our quest to understand Treasury’s recent moves in the market, we’ve identified three overriding principles:
No Great Depression on my watch, got it?
1. Prevent the Second Great Depression
2. Keep the GSEs in the loan-buying business.
3. Do as little as possible, if that
The first is the goal that can never speak its name, and the third has been trampled to death in the ink spilled over the falling financial dominoes.
But even as these big steps have stamped down Wall Street, the remaining boundaries are really important too, and so far underappreciated.
These principles are good enough, they’re smart enough …
4. Support the debt holders. That’s the lesson of several post-conservatorship moves, as detailed in Secretary Paulson’s September 7 statement, which is a model of clarity, starting with its statement that “Treasury will ensure that each company maintains a positive net worth.” Further:
The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.
Treasury will lend capital into the GSEs as required.
Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS.
“We’re climbing into the lifeboat with you; now, let’s all pull together”
During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we’ve seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate.
This is exactly equivalent to a central bank buying its own currency to prevent a foreign-exchange slide, or management buying back its common stock when it thinks the market has undervalued it.
Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury’s temporary authorities in December 2009.
FHFA also directed the GSEs to pay their normal third-quarter preferred dividends, with the nice distinction that the obligations had been incurred before the conservatorship. Personally, I think this was merely a convenient excuse to buy time cheaply, and that Treasury will find a way to allow the GSEs to pay the fourth quarter dividends when they come up.
5. Discourage reliance. Sure there’s moral hazard – it’s littered all over Wall Street. But before you Wall Street CEO leaps into the government’s accommodating arms, take a look at the massive prices extracted from your predecessors:
We’re from the government and we’re here to help you
That’s the lesson of the AIG warrants for 79.9% of the company that Treasury picked up for nothing.
And the 79.9% warrants in Fannie/ Freddie for $1 billion.
It’s also the lesson of the nasty coupon rate on the GSE’s preferred (10% and 12% under certain circumstances.
Translation: You want to rely on our balance sheet? Get ready to surrender your equity.
6. Disrupt as few other markets as possible. Long ago, I posted about the curious collection of assets that made up the GSEs’ regulatory capital base, particularly in the context of their recent buying of what appeared to be subprime loans. The GSEs in fact had a large slug of non-cash assets in the form of ‘deferred tax assets’:
If a company has tax losses, it doesn’t get a rebate from the Treasury (unless it ‘carries them back by amending the tax return from a previous year), so they can be carried forward and used against future taxable income. The deferred tax asset represents the estimated savings (losses times projected effective rate, plus unused credits like LIHTCs) – and they go on the balance sheet as a capital, implicitly ‘just as good as cash.’
These assets won’t be much use if Fannie and Freddie need to come up with quick cash.
Some (like LIHTCs) could be sold, although right now the LIHTC market is in a ground-hold.
Not many new syndicates taking off
At the end of the first quarter, Fannie had deferred tax assets of $17.8 billion, equal to 45% of total shareholders’ equity, while they were $16.6 billion at Freddie, slightly more than [100% of] total equity.
To get to use these assets, which generally have lives of about 20 years, Fannie will need to generate about $50 billion in profit and Freddie about $47 billion. Between 2003 and 2007, Fannie posted net income of $19.7 billion while Freddie’s total profit was $7.4 billion.
If we use those figures as representative, Fannie Mae has a 10-year backlog of deferred tax assets, and Freddie Mac a 25-year backlog.
When it becomes unlikely that a company will use their deferred tax assets, they often write down a portion of them. Fannie and Freddie have yet to do so.
A Freddie Mac spokesman said, “We feel very comfortable about how we’re operating our business under the current regulatory environment.”
What else could one say? “You’re right, we should write these down, thanks for pointing it out”?
Now you mention it, we shoulda done that a long time ago
In a normal liquidation – even in a normal Chapter 11 reorganization – the receiver would immediately clear all non-cash assets by selling them, for cash, at whatever price they would fetch. But Treasury isn’t doing that with the GSEs’ LIHTC equity positions:
“We do not expect either company to liquidate its portfolio of LIHTC or mortgage-revenue bonds.”
They might as well have posted a giant sign, no fire sales here.
The GSEs’ holdings of existing LIHTC equity are so massive that if they dumped them right now – when the LIHTC market itself is undergoing its own pileup in slow motion – would simply create huge downward pressure on LIHTC pricing, with major dislocation and ripple damage in the nation’s affordable housing production pipelines.
Watch out for the guys behind you
Such a move would be in the normal interests of shareholders, but is not in the national interest.
By electing not to destabilize LIHTC markets, Treasury is placing country over conservatorship. I think that’s right – and it’s consistent with Job 1 – but it’s nevertheless remarkable delicacy and foresight that has gone unremarked.
7. Ignore depressed prices in favor of intrinsic values. Here’s another excerpt from Secretary Paulson’s September 7 statement:
The agencies 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, whether realized or unrealized, are likely to reduce their regulatory capital below “well capitalized.” The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.
8. Keep the optics good. When you’re saving the country, you have to have the country’s support, so cannot be blind to the optics.
Short and sweet
Isn’t that charming? “The Enterprises should not make such payments to these individuals and directed the Enterprises accordingly.” That’s sovereign power talking, and it’s mindful of the external optics.
No golden parachutes? None at all?
9. Except as otherwise provided, let the market work. Sorry, Lehman Brothers.
Why did it have to be me?
Take a warning, WaMu.
I wouldn’t count on it
By their works, ye shall know them. When you’re the government, each move is a precedent, whether you like it or not. For three gentlemen as smart as these, they’ve known that, meaning they’ve had a set of principles for each decision.
“Well, it you’re a user¸ then everything you’ve done has been according to a plan … hasn’t it?”
The statute gave Treasury too many powers, and through those excessive powers, Treasury inadvertently cratered Fannie and Freddie – perhaps in the national interest, but certainly to the shareholders’ detriment. (Perhaps that means the shareholders will eventually get compensation, as they should.)
Now Treasury/ Fed has to start defining its principles and making those principles manifest.
Deism, a philosophy numbering among its prominent adherents Voltaire and Thomas
We dance to God’s tune
A deft straddle between the Enlightenment’s need for reason and the scientific-method approach to understanding, and the corresponding religious and political need not to repudiate Christian (particularly Catholic) orthodoxy, it enabled science to advance without overthrowing dogma.
Markets cannot cope with omnipotence; they need rules, and they need science. I don’t blame the troika for issuing decisions rather than writing a new financial constitution – there will be time for that. But stake by multi-billion-dollar stake, Treasury is bounding its own powers, and binding itself to the principles of the Paulson Doctrines.
I resist the siren call of omnipotence
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