The stock of the Federal National Mortgage Association (FNMA), or Fannie Mae, the embattled mortgage lender, plunged beneath $4 in morning trading, lending credence to recent speculation concerning a possible government bailout involving FNMA and its sibling, the Federal Home Loan Mortgage Corporation (FHLMC), also known as Freddie Mac.
No one wants to see a bailout (that is, other than the holders of the senior secured debt, like PIMCO) of the government-sponsored enterprises (GSEs), especially someone as hawkish on fiscal and budgetary issues as myself; however, the fiscal conservatives who still advocate for the do-nothing, or let-them-fail, approach have pretty much taken themselves out of the conversation. The passage of last month’s Housing and Economic Recovery Act of 2008 has settled the question, for better or worse, of whether we will let the GSEs fail (the answer is no).
The only serious conversation going on at the moment is what the bailout will actually look like.
In any government bailout, the competing interests at stake are much the same as in any restructuring event. There are holders of equity – of common and preferred stock – who are always last in line to recover their investment. Then there are the holders of debt, with the senior lenders at the head of the pack. A government bailout can entail more flexibility than an ordinary restructuring, especially vis-à-vis a financial company, as the Federal Reserve, Treasury Department, and Congress can dictate more or less by fiat how the restructuring proceeds, who gets drowned, who gets a haircut, and who gets away scot-free.
The PIMCO-Greenspan Plan
To date, the GSE bailout game has been all about striking the right balance in a restructuring plan. There are some folks out there who want the government to nationalize the GSEs, recapitalize them, clear up the balance sheets, break them up, and then spin them back out into the marketplace, much as a private equity buyer of distressed companies might do it. In such a scenario, the shareholders gets soaked to the benefit of the debt holders, which is how a restructuring usually unwinds. There would be a small added benefit here as well – many US banks, especially small and regional banks, hold significant chunks of GSE debt, some of which gets calculated into their capital requirements. In other words, the health of several regional banks across the country might depend in part on the valuation of their GSE debt holdings. The downside of this approach should be clear: it creates a strong disincentive in the marketplace for anyone to purchase equity in Fannie and Freddie (or their progeny) in particular, and in US financial institutions in general. Bailouts almost always entail drowning those who hold equity. Also, many of those same banks that hold GSE debt also hold preferred shares of GSE stock, stock that would have to be written off in a bailout.
But this has been the position of Bill Gross, manager of PIMCO’s Total Return bond fund. Of course, it would be his position. The gang over at Minyanville demonstrated last year his fund’s overexposure to GSE debt. More surprising is Gross’ ability to get former Fed Chairman Alan Greenspan to shill for him on national television. Greenspan might truly believe that this is the lesser evil in terms of a GSE solution, but the blatant conflict of interest in his commentary should have led him toward more discretion and transparency in publicizing his thoughts.
Alternative Plans
There are other ways to proceed here that are, to understate things, non-traditional. Over at The New York Times website, The Deal Professor has an excellent primer on the relevant laws – especially the impact of last month’s housing bill – at play in a bailout scenario, and he notes some curious avenues of action that would not necessarily wipe out all the equity holders. He explains:
“However, a liquidation (at least in the first stage) would likely create much uncertainty in the companies’ operations and instability in the market. So instead, the government will want to get control and stabilize the businesses. Then it would begin to dismantle them.
“This means that in any bailout, the injection must come early, and come with that stability. Subsequently, with new funds, the bailed-out entity can return to profitability, providing assets for the old shareholders.”
Now, obviously, this above scenario leaves gaps and holes in time where innumerable alternatives could present themselves, but by and large, the general point made above is well taken. If the government does effect a bailout, it makes sense that the GSEs’ capital structure be addressed early on, but not in such a timeframe and not in such a manner that would preserve existing shareholder value. Having said that, however, it can’t move so swiftly and unequivocally as to suggest that the US government is, in effect, taking on the liabilities of the GSEs, nor can the government take the companies into conservatorship without the same effect, which would create massive financial havoc on Uncle Sam’s already crippled ability to raise capital and finance debt. So, at the end of the day, the government is trapped between the proverbial rock and hard spot. Fairness – and political expediency – would suggest that it is vitally necessary to wipe out the existing shareholders, to punish them, in effect; however, the ongoing financial health of the Republic might depend on creating value for existing shareholders, if only to avoid the appearance or reality of Uncle Sam taking on directly the liabilities of these enterprises, which would double the size of the entire federal debt to over 100% of GDP. And let’s not forget that among the major shareholders here are banks and insurance companies already saddled with massive write-downs related to debt securities.
This is a lose-lose situation, to be sure, so how to proceed?
The Lesser of Two Evils
Let’s begin with the doomsday scenario, formerly unthinkable, that the US Federal Reserve could fail and that the United States could default on its debts. The train of events most likely to produce such an outcome would be more likely to occur if the government were to take on the GSEs’ liabilities, so as a starting point, we should assume that a government bailout of the GSEs will do whatever is necessary to avoid this outcome. Once the argument is cast in these terms, a strong case can be made for preserving existing shareholder value, despite the obvious political unpopularity such an outcome would entail. It is, however, the only course of action that would steer clear of a potentially massive financial meltdown for the US government.
Best that I can tell, most large shareholders of GSE stock have already taken huge losses. The last round of capital raising for Fannie Mae took place when the stock was trading in the mid-30s (I think). Those investors have already lost over 80% of their investment. Wiping out the remaining stock value really doesn’t accomplish much at this point – the damage has been done. Even if investors could recover seven or eight dollars per share (as much as 25%-30% more than current value), they’re still way underwater.
Conversely, if the government were to capitalize the GSEs while preserving some small fraction of shareholder value, the debt holders’ long-term outlook isn’t much affected. Only those folks who speculated on GSE debt and bought in at rock-bottom prices, expecting a windfall profit upon nationalization of the companies, would be disappointed. I get the impression many holders of debt would rather see the companies go under and taken over by the government. The creditors would then profit from the resulting asset sales and liquidation, but no one else involved – the government, the taxpayer, the shareholders, the financial system at large – would see any benefit from this.
Ordinarily, I would never suggest such a restructuring, but I don’t see any other way out of this in the short term that would preserve the creditworthiness of the US government or get taxpayers off the hook. The important thing to bear in mind here is that, no matter what we decide in structuring this bailout, the taxpayer will suffer, so it makes sense to me to act in a way that reduces future exposure in the short term and that enhances financial stability throughout the system. Handing the creditors a windfall profit does not accomplish this.
What to do with the GSEs after they are out of immediate danger is a different question altogether, but first things first.
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