As you are aware, news broke on Friday that a “plan” will be announced for the GSEs. In typical animal fashion, stocks surged, led by the financials. I have been pounding this topic for months because how they handle this situation matters hugely.
I have always maintained that if they nationalize these firms and explicitly guarantee the GSE MBS going forward only that the mortgage and housing industry will not get hurt. It won’t really change anything other than maybe over time have a small lowering effect on rates. But over the near-term, unless the Gov’t brings back stated-income and 100% interest-only loans, this will have little noticeable impact. But at least the uncertainty will gone over the GSE’s fate, which is one of many moving parts to the global credit crisis.
When it comes down to shareholders, who cares? They knew they were buying options when they bought the stock in the first place. Their preferred debt has to be handled with more care, so as not to trigger an “event of default” that trips trillions of dollars in credit default swaps, creating an even larger problem. Their short-term debt, including the $223 billion due soon, will just have to be dealt with.
The big challenge is with an open-ended, retroactive bailout of $5.2 trillion in old-vintage mortgage backed debt, much of it created during the worst times in the mortgage and housing market. The GSEs have some $700 billion in subprime and Alt-A and a couple trillion more they guarantee that, due to their faulty artificial underwriting systems during the bubble years, is much more toxic than most think. These securities were explicitly NOT GUARANTEED by the US Government for a long as they have been created. Please see proof here: Have You Ever Seen a Fannie MBS? Bill Gross Must Not Have.
If they do an open-ended and retroactive backing of this debt and put it on the Gov’t’s balance sheet it will effectively go right on the national debt and could do nasty things to Treasuries. This is the same paper that foreign central banks have been selling in favor of US Treasuries in recent months and that Bill Gross has been buying (heavily discounted) in order to get over on the US Taxpayer in the event of a bailout.
I say no! Let that stuff trade on its own strengths and weaknesses. If it is good enough for the tax payers to back it is good enough to stand on its own on Bill Gross’s books. He knew the day he bought it that the GSE MBS were not government guaranteed. He chose to invest anyway because of the healthy spreads over other fixed income paper (and perhaps the belief that, with Alan Greenspan in pocket, he could bully the Treasury into bailing him out).
The losses these investors incur over time will be small compared to the damage that backing the historical Fannie/Freddie debt will do to the world when US Treasuries are clubbed. And when it comes to the housing market it is about the new paper being created and not the toilet paper traded among rich entities. The new, explicitly guaranteed paper will be gobbled up despite their threats to the contrary. After all, what choice do they have? The Gov’t has the ability to do what’s right here and I can’t imagine that Hank Paulson will want the last thing he does in public office to be saddling the US tax payers with trillions of dollars in debt.
My good friend Karl Denninger wrote a great piece on it today I encourage you all to read. Below is an excerpt:
Here’s the set of problems, as I see it.
- Placing the firms into conservatorship (effectively Chapter 11 bankruptcy for them, “prepackaged”) is fine. In fact, it needed to happen a couple of years ago. That’s the good news.
- Running down the firms’ portfolios is both a good idea and is necessary. We simply cannot have these firms play “hedge fund”, and it is clear that the only way to stop it is to strip them of the ability to do so.
- These firms bought, intentionally, nearly one trillion dollarsbetween them of subprime and “ALT-A” no-doc or reduced-doc mortgages. These are not prime loans, they are loans made to speculators, and they are the ones most at risk! We must not and cannot bail these people out.
- Guaranteeing the existing debt of these firms, which was sold with a black-letter statement on the front of every single prospectus, is unacceptable and exposes the United States Taxpayer to the full $5 trillion in debt that these firms hold and control. This is equal to the entire public float of The United States Treasury and more than 1 trillion of it is in the hands of foreign central banks in nations such as China and Japan. They bought this debt with the full knowledge that it was not guaranteed.
- There is every reason to believe that Treasury Bond Yields will shoot higher in the coming weeks and months. If this happens it will “take back” any benefit from this so-called “bailout” immediately, and worse, it will hike borrowing costs across the economy – not just in housing – when we are already in a credit crunch. The result of such an event could be disastrous and it is what I have been warning about for months.
Why do they need the money anyway? Was something going on behnd these scene’s that was not made public? Is this actually a massive failure. Well, the credit markets have been telling us something bad was happening over the past few weeks while equities have been surviving on animal instincts and staying elevated. Perhaps Morgan Stanley while evaluating their options, found that the GSE’s were days away from collapse.
Below is from the House website regarding HR 3221 Housing Bill. Very interesting indeed. This was only SIX WEEK AGO:
The non-partisan Congressional Budget Office says “There is a significant chance — probably better than 50 percent — that the proposed new Treasury authority would not be used before it expired at the end of December 2009.” CBO estimates that, if used, the federal budgetary cost of this proposal would be $25 billion over fiscal years 2009 and 2010.
Because CBO estimates that these provisions could increase direct spending, we need to waive PAYGO rules in order to consider it. The bill requires the Treasury Secretary to make an emergency designation before using the authority — certifying that he is acting to provide stability to financial markets, prevent disruptions in the availability of mortgage finance, protect the taxpayers, and facilitate an orderly restoration of private markets. No spending would occur unless the Secretary certifies that there is an emergency that requires immediate action. However, if those conditions are not met, there would not be any increase in the deficit as a result of this legislation.
Finally, Bill Ackman has a real plan announced publicly a couple of months back, which many think could be along the lines the Treasury is thinking given they called their plan “creative” at the onset. A blanket bailout of everyone and the shareholders getting zero has been thrown around for months and is the least creative and the most destructive.
September 5, 2008 The Honorable Henry M. Paulson, Jr. Secretary United
States Department of the Treasury 1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220
Re: Fannie Mae/Freddie Mac Restructuring
Dear Secretary Paulson:
We understand that a Treasury plan for Fannie/Freddie (“the GSEs”) may
be announced this weekend. We thought you might find useful some further
thoughts on potential GSE solutions.
As you are likely aware, we had previously distributed a proposed
restructuring plan for the GSEs. In that plan, under a prepackaged
conservatorship, equity interests would be extinguished, subordinated
debt would be exchanged for warrants, and senior debt would be exchanged
for new senior debt and common equity in the newly recapitalized
entities. The government would write a put to the new common equity
holders which would expire in three years.
It appears, however, that the GSEs may need help more quickly, and
conservatorship may not be triggered until the GSEs are formally
determined to be undercapitalized. As such, in the event the government
needs to inject capital immediately, we suggest you consider the
following transaction (“the Transaction”).
In order to minimize risk to tax payers while being equitable to other
constituents, we suggest that the Treasury consider purchasing senior
subordinate debt in the two companies in an amount sufficient to address
their capital needs in the short to intermediate term. This senior sub
debt would be junior in right of payment to the outstanding senior
unsecured debt and senior to the outstanding sub debt, preferred stock,
and common equity. We refer to the outstanding sub debt, preferred and
common stock as “the Subordinate Securities.”
The issuance of senior sub debt is permitted under the GSE legislation
and under the existing terms of the outstanding debt and equity
securities of the two entities (please see the attached memo for further
details). As a condition of Treasury’s purchase of senior sub debt, the
GSEs would defer the interest payments on the outstanding sub debt
(which can be deferred for as much as five years), and the dividend
payments on preferred and common stock. All of the Subordinate
Securities would continue to remain outstanding according to their
The new senior sub debt should have a market-based coupon and Treasury
should receive low-strike price warrants (penny warrants) for a
substantial portion, i.e., 49% of the two companies. The coupon and
warrant structure should be as close to fair-market-value terms as
possible. The ultimate determination of fairness would be the
willingness of non-government investors to purchase the Transaction
securities on the same basis as Treasury. As part of the Transaction,
the GSEs would deleverage their capital structures by paying down senior
debt from the free cash flow generated by their core businesses further
improving the position of the new senior sub debt.
The benefits of the Transaction are as follows:
• The Transaction can be accomplished under the existing terms of the outstanding GSE securities without any required consent other than from the GSEs.
• The new security would be senior in right of payment to the existing sub debt and preferred stock minimizing the risk to tax payers while providing substantial support to the outstanding senior debt that has been deemed implicitly guaranteed by the government.
• The new debt interest payments would be tax deductible, reducing the after-tax cost of capital to the GSEs, particularly when compared with preferred stock.
• In the event the outlook and performance of the GSEs and their assets were to improve dramatically, the senior sub debt could be redeemed, distributions to the Subordinate Securities could resume, and their values would increase accordingly.
• In the event that the GSEs’ fundamentals continued to deteriorate and they became undercapitalized, the GSEs could be placed in conservatorship. In
conservatorship, their balance sheets could be restructured along the
lines of our original plan or another plan with the Treasury’s senior sub debt treated preferentially to the Subordinate Securities, again minimizing risk to the tax payer.
• The Transaction would be fundamentally fair to all constituents and would respect the existing terms and corporate hierarchy of all outstanding GSE securities.
• The Transaction would minimize moral hazard issues for sub debt, preferred, and common stock investors.
Most importantly, we believe there are serious negative implications for
other large financial institutions in the event the Treasury were to
bail out Subordinate Security holders. The Treasury and OFHEO have done
substantial research on the benefits to capital market discipline from
large financial institutions’ issuance of subordinate debt, and the
destructiveness of the government implicitly or explicitly guaranteeing
See: Report to Congress “The Feasibility and Desirability of Mandatory
Subordinated Debt”, Board of Governors of the Federal Reserve System and
United States Department of the Treasury (December 2000), available at:
“Subordinated Debt Issuance by Fannie Mae and Freddie Mac”, Valerie L.
Smith, Office of Federal Housing Enterprise Oversight, OFHEO WORKING
PAPERS, Working Paper 07 – 3 (June 2007), available at
“Signals from the Markets for Fannie Mae and Freddie Mac Subordinated
Debt”, Robert N. Collender, Samantha Roberts, Valerie L. Smith, Office
of Federal Housing Enterprise Oversight, OFHEO WORKING PAPERS, Working
Paper 07 – 4 (June 2007), available at:
(Due to its length, this URL may need to be copied/pasted into your
Internet browser’s address field. Remove the extra space if one exists.)
“Subordinated Debt and Bank Capital Reform”, Douglas D. Evanoff, Federal
Reserve Bank of Chicago, Larry D. Wall, Federal Reserve Bank of Atlanta,
FRB Atlanta Working Paper No. 2000-24 (November 2000), available at
To the extent the Treasury were to bail out the GSEs’ subordinate debt –
which was: (1) never implicitly guaranteed by the government, (2) always
rated below Triple A by the rating agencies, and (3) held by investors
who knowingly took on the risk of loss in exchange for a substantial
credit spread above the GSEs’ senior debt – it would endanger the
systemic benefits from subordinate debt issuance for every highly
leveraged banking institution in the world and the capital markets at
Furthermore, we do not believe that the Treasury can purchase GSE sub
debt, preferred stock or common stock without incurring an immediate
loss to tax payers because of the enormous amount of existing debt
senior to these instruments. At a market coupon or dividend yield (to
the extent that one were to exist), any debt issued pari passu to the
existing sub debt, or preferred stock issued pari passu or even senior
to the existing preferred stock would require a yield that would be
uneconomic for the GSEs. No third-party investor would purchase these
securities regardless of their terms in light of their junior position
in the GSEs’ capital structure.
Please note that Pershing Square and affiliates own CDS on the
subordinate debt of the GSEs. We also note that nearly all participants
in the capital market debate on the GSEs are either long or short the
outstanding GSE securities.
We are contemporaneously releasing this letter to the public in the
interest of market transparency.
William A. Ackman
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