Paulson and His Life Raft

So much for a day of rest. On Sunday US Treasury Secretary Henry Paulson announced that the government would officially seize control of mortgage giants, Fannie Mae and Freddie Mac. The move was not as unexpected as it was historic. Back in July, Mr Paulson unveiled a more modest plan to rescue the twin lending institutions, effectively obligating the government to stand behind their debt.  According to former Treasury official Ted Truman, "Freddie and Fannie have been de facto nationalized, at least for a while." Instead, the announcement signals that start of a curious, if not uncomfortable, plan to nationalize part of the mortgage lending industry. 

The Treasury's strategy is in four parts. Freddie and Fannie will first enter a period of "conservatoriship" under the Federal Housing Finance Agency. In formal bankruptcy, a court-appointed receiver will restructure a firm's debt. The receiver organizes the capital structure (asset liquidation, payment of bondholders and shareholders) according to specific regulations. Conservatoriship is a diluted form of receivership, except the US government is trying to negotiate with creditors on the fly. There is no established law that regulates such a bailout. As a result, Mr Paulson is navigating unchartered waters.

Second, Freddie and Fannie will have access to a loan facility from the federal government through 2009. In addition, twelve federal home-loan banks will also benefit from this line of credit. While these bank-owned coöperatives have been injecting much needed liquidity into the lending market, they have considerable short-term debt. Of greater concern to these banks, however, is borrowers' falling collateral. The properties and assets used to secure these loans are eroding with the housing market.

Third, the government will purchase $1 bn of preferred stock at no cost, while gaining rights to 79.9% of Freddie and Fannie's common stock at the nominal price. As part of the agreement, the Treasury will buy mortgage-backed securities from the firms, amounting to another $5 bn in September.

Finally, the US Treasury will become a buyer of last resort for any bonds packaged by Freddie and Fannie in the event that open market demand evaporates. While this measure guarantees that the lending institutions will stay above water, it could come at a fantastic cost to the American taxpayer. Indeed, analysts have speculated that the bailout may come with a price tag in excess of $200 bn. 

Conventional wisdom says that the US simply could not allow Freddie and Fannie to fail. These multi-trillion dollar lenders own or guarantee about half of the $12 tn American home loan market. And with housing prices still falling at nearly 15% per year, the credit crisis would rapidly lead to negative equity for many families in the US. No doubt the Treasury's announcement brings much-needed relief to homeowners. Facing a national mortgage default rate of 9%, the government will now be able to cut payments or extend the terms from 30 to 45 years for borrowers. Stockholders are less enthused. Sunday's announcement eliminates billions of dollars in dividends on preferred stock, which will ultimately undercut the investment value of common stockholders as well. Not surprisingly, trading on Monday saw Freddie and Fannie's share price drop more than 80% to less than $1 per share.

International markets, however, rallied at the news of the massive credit-default swap. In gains not not seen since April, banks across Europe and Asia (who were effectively underwriting Freddie and Fannie's debt) strengthened, which sent the MCI World up 2.1 percent. Investor enthusiasm belies the stopgap nature of the bailout. Only the next 15 months of this mortgage crisis are scripted. By then a new Congress and new administration will have to thin the portfolios of these lending giants. Mr Paulson's billion dollar life raft may well have saved the ship, but the waters ahead are still rough.