Great article on the WSJ about this fiasco!
Weekend at Henry's - WSJ.com
Weekend at Henry's
September 8, 2008; Page A18
In the 1989 movie "Weekend at Bernie's," a pair of young executives create the illusion that their dead boss is still alive to keep a party going. That's not too far from the premise of this weekend's Treasury bailout of Fannie Mae and Freddie Mac, the mortgage giants that have become financial zombies.
Treasury Secretary Henry Paulson wants to prop up the walking dead so the world keeps buying their mortgage-backed securities. His action may calm jittery credit markets, and it may get the companies through the current mortgage crisis -- albeit at enormous cost to American taxpayers. The tragedy is that he and Congress didn't act 18 months ago -- when the cost would have been far less -- and that he still isn't killing the Fannie and Freddie business model that has done so much damage. These corpses could still return to haunt us again.
* * *
At least Mr. Paulson has finally figured out he's been lied to. He arrived in Washington fresh from the Wall Street turnip truck saying that the battle over the two government-sponsored enterprises (GSEs) was nothing but a scrap between "ideologues." So he bought the Congressional line that Fan and Fred weren't a problem and would help financial markets through the housing recession. Even as he won new power this summer to add taxpayer capital to the companies, he said he had no intention to use that power and that he wanted to sustain them in their "current form." That political theater merely prolonged the market agony, while giving the companies incentive to take even greater risks.
This weekend's formal rescue puts an end to those illusions. Treasury and the new GSE regulator -- the Federal Housing Finance Agency -- both acknowledge that the companies are facing huge mortgage losses that will soon overwhelm their capital cushions. And this time Mr. Paulson has at least demanded something in return for his blank taxpayer check.
The new federal "conservatorship" is a form of nationalization that puts regulators firmly in control. The feds fired the company boards and CEOs, though the clean up needs to go further to change the corporate cultures. Both companies remain Beltway satraps that hire for reasons of political connection, not financial expertise.
The taxpayer purchase of preferred stock means that the feds will own about 80% of the companies if all the warrants are ultimately exercised. The feds also stopped dividend payments, saving about $2 billion a year. This amounts to significant dilution for current Fannie and Freddie shareholders, and it offers taxpayers some return on their bailout risk if the companies recover.
We only wish Mr. Paulson had gone further and erased all private equity holders the way the feds do in a typical bank failure. Fan and Fred holders had profited handsomely for decades by exploiting an implicit taxpayer guarantee that their management claimed didn't exist. Now that the taxpayers are in fact stepping in, the current common and preferred holders deserve to lose everything. Mr. Paulson apparently wanted to dodge that political fight. If Fan and Fred share prices rally this week, we'll know Mr. Paulson didn't demand enough.
The Treasury chief also gave a free pass to the holders of some $18 billion in Fan and Fred subordinated debt. He did so even though these securities were understood not to have the same status as mortgage-backed securities or other Fannie debt, and even though this will set a bad precedent for other bailouts. Watch for Citigroup's subordinated debt to jump in price as investors conclude that the feds would do the same thing if Citi needs a rescue.
By far the biggest risk here, however, is that the companies could still emerge with their business model intact. That model is the perverse mix of private profit and public risk, which gave them an incentive to make irresponsible mortgage bets with a taxpayer guarantee.
Mr. Paulson could have ended that model immediately by putting the companies into "receivership." Both companies could have continued to securitize mortgages, even as their riskiest businesses were wound down. But Treasury says its lawyers at Wachtell Lipton advised that receivership might have triggered default claims and thus caused a run on Fannie and Freddie debt. We hear there's some legal debate on that point. And in any case, had Mr. Paulson acted sooner and given markets time to understand that receivership doesn't mean immediate liquidation, the risk of a run might now be far less.
The Treasury plan does at least put some useful limits on Fan and Fred risk-taking, albeit starting only in 2010. Until the housing market bottoms out, presumably in 2009, the feds want the two companies to keep securitizing and guaranteeing mortgages as they do now. But in January 2010, the companies will have to start reducing their portfolios of MBSs by 10% a year, to a total of $250 billion. That will reduce one giant source of systemic financial risk.
Also in 2010, the companies will have to start paying a fee to the feds in return for their taxpayer guarantee. The fee -- which could be paid in cash, or in preferred stock and thus add to the government's controlling stake -- is designed to level the playing field with private mortgage securitizers.
Treasury says all of this will provide a motive for Congress and the new President to change how Fan and Fred do business, and in the meantime the conservator has also ordered a stop to their political lobbying. It's also nice to see that on this point Mr. Paulson has found religion. In his statement Sunday, he blamed the need for a bailout on "the inherent conflict and flawed business model embedded in the GSE structure." Welcome to our merry band of "ideologues," Mr. Secretary.
The Treasury chief has nonetheless decided to leave the hardest political choices to his successor, who will have to face down the usual phalanx of Fannie apologists: Democratic barons Barney Frank and Chuck Schumer, the homebuilders, various Wall Street sages and left-wing journalists.
Both Barack Obama and John McCain are now saying sensible things about the need to change the companies. But who knows how the political mood will have shifted once the housing slump passes. It's easy to imagine the next Treasury Secretary concluding that he also thinks the fight for permanent reform is too difficult. Then we are back to the same old stand.
* * *
The Fannie-Freddie bailout is one of the great political scandals of our age, all the more because it was so obviously coming for so long. Officials at the Federal Reserve warned about it for years, only to be ignored by both parties on Capitol Hill. The least we can do now is bury these undead monsters for all time.