Crunch Time

Thus far into the credit crunch, we have generally been able to cope with each crisis through a combination of two methods: existing plans [IndyMac and Subprime Lenders] and negotiated solutions [Bear Stearns and Countrywide]. We have now come to the climax of the story – Fannie and Freddie.

The world is scared of Fannie Mae and Freddie Mac – and for good reason. These Government Sponsored Enterprises (GSEs) have significant problems. They are financial guarantee companies, and like the other financial guarantee companies [the monolines ABK, MBI and the mortgage insurers MTG, PMI, RDN, TGIC], they are being thought of as likely to default. The GSEs have negative book value if their portfolios were marked to market – in other words in a timely liquidation scenario there would currently be a loss for debtholders. This is significant in that FNM and FRE have been considered “backed” by the federal government, which is why they have been assigned AAA credit ratings, even though they would not be worthy of such ratings on their own.

It is common thought that Fannie and Freddie really are “too big to fail” – and not just for the United States. Many foreign central banks hold much of their dollar denominated reserves in Fannie and Freddie paper. Unfortunately neither existing plans [bankruptcy] nor a negotiated solution [sale of the companies] would be a viable solution, as the GSEs are too large for a sale and too important for bankruptcy.

There are really only two options if we recognize them as being too big to fail (and therefore rule out bankruptcy) and also assume that they will need assistance:

1) The US government explicitly backs the GSEs debt
2) The US government injects additional capital into FNM and FRE

The first option cannot happen because this would likely cause the national debt to double, and the country would probably lose its AAA credit rating [per Moody’s early 2008]. Therefore the second option is the only logical outcome [also Secretary Paulson has in the past indicated that the government will not back Fannie or Freddie debt].

The capital injection could be completed in a number of different manners – junior (subordinated) debt, preferred stock, or common stock. The public feeling amongst our financial system big wigs is that, to avoid moral hazard, the common shareholders of Fannie and Freddie should pay the consequences of having invested in a GSE and lose the majority of their investment. A common stock capital injection would put the government’s claim at the same level as existing shareholders – moral hazard. Subordinated debt probably would have the effect of propping up the stock price. On the other hand a convertible preferred issue with highly dilutive terms would punish the common shareholders and provide the capital that FNM and FRE are thought to so desperately need.

There are models in past governmental bailouts of what works, and what doesn’t:

Penn Central Railroad 1970 – Penn Central was a failing conglomerate making ill-advised purchases of money losing non-railroad companies in a scheme to borrow ever more money for real estate investments. Eventually the corporation approached the government for $300 million in aid. Nixon approved the package ($750 million for railroads, of which $300 was for Penn Central) but congress did not approve the aid. Penn Central declared bankruptcy in June of 1970 leading to the creation of Conrail and Amtrak.

Lockheed 1971 - $250 million in federal loan guarantees.

New York City 1975 – Billions lent by federal government to the city at a rate of the one year treasury plus 1% on a term of 1 year with annual renewals.

Chrysler 1979 – 1.5 billion in federal loan guarantees, and creditors forced to renegotiate debt at 30 cents on the dollar. Deal allowed Treasury to participate in upside in the stock, and eventually the government made money. Recommended reading: http://www.time.com/time/magazine/article/0,9171,947356,00.html
http://www.heritage.org/research/EnergyandEnvironment/bg276.cfm
http://www.cato.org/pubs/pas/PA00Aes.html

Savings and Loan Intuitions 1980 to 1989 – The rules were changed for Savings and Loans such that insolvent institutions were not identified and shut down quickly by regulators, but rather hidden and allowed to remain open. Capital requirements were lowered, and fake capital (called “capital certificates”) were issued to troubled savings and loans.
http://en.wikipedia.org/wiki/Savings_and_Loan_crisis
http://www.fdic.gov/bank/historical/s&l/

Airline bailout 2001 – Playing the “terrorism killed our industry” card, the airlines received $10 billion in loan guarantees and $5 billion in cash from Congress.

I expect that the final solution to the bailout of Fannie and Freddie will have multiple prongs: 1) The US Government will inject over half of the needed capital through the use of convertible preferreds 2) The US Government will lean on other central banks to inject most of the remaining needed capital, probably through the use of subordinated debt 3) The Fed will ensure liquidity for the GSEs in the event they cannot roll their debt by providing access to the discount window [already known to be the case] 4) Fannie and Freddie will raise additional capital through the issuance of debt and preferred stock in the public markets. Through the provision of additional capital and liquidity Fannie and Freddie will be allowed to remain open for quite some time, and if the housing market turns in 2009, as I expect, the government will again ultimately make money on their bailout.