Phony Accounting on Fannie, Freddie Rescue Legislation

I got this far in the Wall Street Journal article, “Capitol Hill Storm Envelops Fannie-Freddie Rescue” and started seeing red:

The Congressional Budget Office is expected to estimate the cost of Treasury’s proposals to the federal government to be in the tens of billions of dollars, according to people familiar with the matter. That estimate is expected to reflect the likelihood that an equity investment will be made by the federal government and that the line of credit might also be tapped.

This cost estimate is a fraud. The so-called rescue plan is merely a first installment on whatever the cost of shoring up Fannie and Freddie will ultimately be. The CBO analysis almost without a doubt fails to reflect the fact that this initiative de facto makes the GSes wards of the state. It’s the worst of all possible worlds, because the government is in effect assuming unknown but possibly large liability with no (if Paulson gets his wish) or little (if the Democrats add a few restraints) controls over the GSEs.

If taxpayers pay one plugged nickel to support the GSEs, shareholders should be wiped out and the GSEs should be nationalized. But instead, the powers that be are pretending we can have our cake and eat it too. We can have a “backstop” and the rest of the world will be satisfied that the US is supporting Fannie and Freddie. No cost (what’s a mere “tens of billions”) yet we’ve satisfied the demands of our friendly funding sources. Ain’t finance grand?

With this move, the US crosses a Rubicon. We have now acted as if the implicit guarantee of Fannie and Freddie debt, which in fact is disavowed in all their offering documents, is now real. This is just the down payment on an open-ended commitment. Remember that lovely word from the 1960s, escalation? From a few military advisers in Vietnam a costly war grew.

It would take a detailed analysis of the GSEs’ exposures, analyzed against multiple scenarios of how the housing crisis will evolve, to determine what the real cost of this bailout might ultimately be. I guarantee this work has not been done. It would take considerable manpower and cooperation of both Freddie and Fannie, when both insist that things are fine and this backstop, as they like to call it, isn’t necessary, but those irrational markets might benefit from reassurance.

I have no independent view of how much this salvage operation might ultimately cost, since the damage also depends on how rapidly GSE exposures increase and how stringent their lending practices are. However, here are some datapoints from those who have pondered the GSEs a bit more deeply:

Chris Whalen at Institutional Risk Analytics:

FRE and and FNM operate at much higher leverage ratios than any bank or hedge fund….A 2001 study by the GAO suggested that the GSEs might warrant a “A” rating as private stand alone entities, but we’d argue for closer to “BB” based on the leverage of FRE and FNM. We recall the colloquy between Alan Greenspan and then-Senate Banking Committee Chairman Richard Shelby (R-AL), when the former explained why the GSEs could not be supervised using the safety and soundness rules employed by regulators with banks. The reason? Woefully inadequate capital compared to commercial banks. JP Morgan Chase (NYSE:JPM) or BAC, for example, have almost as much bank-level capital as the GSEs combined supporting one fifth of the commitments.

With spreads over Treasury debt on GSE paper widening, neither FNM nor FRE can long survive – even if you could convince private investors to provide new private capital.

Nouriel Roubini from “How to Avoid the ‘Mother of All Bailouts’“:

….. the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency – as of now and in the worst scenario of $200 to $300 billion – the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or – for unchanged face value – a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

Bill Ackman, in his resturcturing proposal, advocated restructuring Freddie and Fannie by, among other things, effectively wiping out current equity and subordinated debt holders (they get warrants and a fortune cookie) and giving current debt holders new paper: debt with 90% face value of their holdings, and equity with a face value of 10%. Investors could put the new equity to the Federal government at face for the first three years. With Fannie and Freddie each having senior debt of roughly $750 billion, the most this plan could cost is $150 billion. However, some looking at the plan contend that it still leaves the GSEs with too little equity (ie, a bigger debt reduction is needed).

I’d be interested in hearing of other analyses, but these views suggest “tens of billions” is too light.

And an additional, important cost has been completely omitted: higher Treasury interest rates as the distinction between GSEs and Treasuries is effectively eliminated. We discussed this in “Treasuries Starting to Look Like Senior Debt of GSEs.” Bloomberg columnist Mark Gilbert provides corroborating information in “There’s Nothing Sacrosanct About U.S. AAA Rating“:

Over a plate of pasta on a January afternoon at Cecconi’s restaurant in London, Pierre Naim outlined his plan to make money by betting that the U.S. government’s financial reputation would crumble like Parmesan cheese.

Naim, who has owned the Nassau, Bahamas-based hedge fund Rainbow Advisory Services for more than a decade, was considering credit-default swaps…

The swaps had traded infrequently at less than 2 basis points, making for a very cheap bet. Naim put a $50 million trade on at 12 basis points — “I was a bit late,” he says. This week, concern the U.S. is becoming addicted to financial bailouts drove the swaps to 18 basis points. Naim still isn’t selling.

Sensible, sane people are starting to question whether the U.S. can hang on to its AAA credit rating. The prospect of an extra $5 trillion or thereabouts leaking onto the U.S. government’s tab from Fannie Mae and Freddie Mac has spooked investors. As the man almost said, a trillion here and a trillion there, and pretty soon you are talking about real money.

“Where does the government stop?” asked economist Dennis Gartman in his Gartman Letter research report this week. “Shall all farmers be bailed out? Shall General Motors and Ford, who are seemingly heading toward oblivion, be bailed out? Where does this mission creep end and how much shall it cost, and how badly shall the dollar be battered in the process?”….

Financial markets and U.S. legislators alike have derided U.S. Treasury Secretary Henry Paulson’s plan to bail out the mortgage lenders. One of the two key elements is illogical, while the second is plain outrageous.

Just last week, Fannie Mae said it “has access to ample sources of liquidity, including access to the debt markets.” Freddie Mac said it was “adequately capitalized, highly liquid and an essential part of the nation’s housing system.” Either they are being economical with the truth, or the decision to let them borrow from the Federal Reserve’s discount facility is window-dressing that serves no real purpose.

Worse is the scheme to allow Paulson to dip into the nation’s tax revenue to purchase shares in Fannie and Freddie — shares that investors have already deemed to be almost worthless. If the mortgage lenders can’t survive in their current form, the government shouldn’t be defending the indefensible.

In April, Standard & Poor’s said the risk that the U.S. would have to prop up its so-called Government Sponsored Enterprises posed a bigger threat to the country’s AAA rating than its willingness to underwrite securities firms.

S&P estimated that even in a worst-case scenario, bailing out the broker-dealers would cost the U.S. less than 3 percent of gross domestic product, while Fannie, Freddie and Federal Home Loan Banks might drain as much as 10 percent of GDP. Defending the GSEs “could create a material fiscal burden to the government that would lead to downward pressure on its rating,” said John Chambers, chairman of S&P’s sovereign rating committee.

Nikola Swann, S&P’s primary U.S. credit analyst, said last week that the U.S.’s top grade isn’t at risk. Steven Hess, a senior credit officer at Moody’s Investors Service, also said that rescuing Fannie and Freddie doesn’t trigger a downgrade.

Well, they would say that, wouldn’t they? Given the threat of increased regulation in their biggest market, the raters are unlikely to give the U.S. authorities even more reason to beat them up. There is an outside chance, however, that Fitch Ratings might be more willing than its peers to take the plunge.

It has happened before. In 1998, Japan was wrestling with a belated plan to bail out its ailing financial industry, which was besieged by 77 trillion yen (then $579 billion) of problem loans and an economy in its third consecutive quarter of contraction.

Fitch was first to sanction the indignity of a rating cut, dropping Japan to AA+ in September. Moody’s followed with a one- level reduction in November, while it took S&P until February 2001 to change its assessment.

Note that US GDP is roughly $14 trillion, so S&P’s estimate of the cost of shoring up the GSEs plus the Home Loan banks is as much as $1.4 trillion. And as we said, none of these estimates allow for higher Treasury borrowing costs.