Sunday Night Stream of Consciousness on the Bailout

The Treasury announced a bailout package for the GSEs this evening. The proposal contains three pieces. The Treasury will seek to increase the nominal line of credit to the agencies (I believe a little over $2billion currently) and will need Congressional approval for that action.They will also seek approval from the Congress to make equity investments in the GSEs.

Finally, the Federal Reserve has once again been drafted to open the discount window and make it available to both FNMA and Freddie Mac.

This would seem to make explicit the guarantee of agency debt which has always been implied. The spread between agency debt and Treasury debt should contract dramatically and the only difference should eventually be based on liquidity issues. (This should over time cause a bit of a contraction in trading desk employment as there will be a reduced need for agency traders. The optimal skill for an agency trader going forward will be the ability to trade the myriad of callable paper that the agencies have issued. There is no similar treasury paper.)

Details are lacking here. I have visited other websites and the Treasury website and have found little other than the sketchy details I have penned here. To really formulate an opinion on this rescue I think that we need to wait and see the particulars. Until the details are available my instinct is that this is not a great idea. The taxpayers are assuming a massive set of liabilities and assets with no clear path to the ultimate outcome. I think that when we think this through the outcome will be that the laissez faire approach which has been in vogue the last three decades will be in serious jeopardy. It has been that approach which the regulators supported and allowed for the creation of organizations which are too big to fail and has now threatened the system twice in a four month period. Regulators and government have violated the most basis principals of risk management by permitting such massive accumulation of capital in the hands of a few.

I think the pendulum of history is about to sweep back in the opposite direction and it will reintroduce a level of government involvement which has not been seen in quite some time.

What type of equity will the Treasury purchase? What is the trigger for such an event? At what price will the taxpayer be long the housing market? I suspect that the Bear Stearns model will apply here and if the treasury does get involved as an owner it will mean a very sad ending for current stockholders.

When I worked at JPMorgan in the 1990s I regularly preached that the business model of these enterprises was a fantasy. If one purchased the stock of these institutions your bedrock assumption was that they could grow there balance sheets to infinity. They made money by issuing cheap debt with the implied backing of the taxpayer and reinvested it in a higher paying asset. It does not take a rocket scientist to do that but it only works if they can issue increasing greater amounts of debt. Well now the music has stopped and they do not have a seat.

This has been stream of consciousness and I apologize.

One final thought which might apply to bond trading in the short run. If the agencies do need to tap the discount window, it will require the Federal Reserve to sterilize those actions with sales of treasury coupon securities. The Federal Reserve has already lent out a significant portion of its balance sheet in an earlier iteration of this crisis. To the extent that they need to supply significant liquidity to FNMA and Freddie that might engender another set of problems.

This is like something out of Alice and Wonderland as things get curiouser and curiouser.

Originally published at Across the Curve and reproduced here with the author’s permission.Related RGE Content:

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