Time for Hank Paulson to Do the Right Thing and Nationalize the GSEs

On Friday and as was expected, IndyMac Bank, F.S.B., Pasadena, CA, was closed by the Office of Thrift Supervision, the FDIC was named conservator and a new bank was created. Of note, no buyer was announced at the FDIC press conference.

The $32 billion asset IndyMac has about $1 billion in uninsured deposits, according to the FDIC, which is reopening the bank today after a weekend hiatus. The estimated cost of the IndyMac resolution to the Deposit Insurance Fund is between $4 and $8 billion or nearly a quarter of total assets on the high end.

This morning Americans should be very grateful to the dedicated professionals at the FDIC and OTS who handled this difficult process. We should also heap steaming piles of radioactive scorn on Senator Charles Schummer (D-NY) for his bombastic statements prior to IndyMac’s failure. Schummer’s selfish actions deserve censure by the Senate.

Last week, while the short seller mob in hedge fund land and their co-conspirators in the financial media were focusing attention on the GSEs, Countrywide Financial (NYSE:CFC) filed its last 8-K with the SEC, detailing the movement of significant assets from the parent of Countrywide Bank FSB to other affiliates of the Bank of America (NYSE: BAC) group.

As we predicted, the huge CFC servicing portfolio was transferred immediately after the merger with BAC closed and at well above fair value, some $19 billion. This valuation, $2 billion over carrying cost, seemingly makes any possible claw-back efforts moot should CFC file bankruptcy.

The insured bank unit has apparently not yet been moved out of what is now called Countrywide Financial Corp, a wholly owned subsidiary of BAC that is remote from the other operations of the bank. We’ll be keeping a close eye on this situation. Once the bank unit migrates to another part of BAC, anything goes.

But of course all eyes are now on Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), the two lumbering government sponsored entities that are the latest financial institutions to suffer from a confidence shortfall. A sharp decline in investor faith last year caused the world of private label securitizations to begin to unravel, then in March hit Bear Stearns and almost Lehman Brothers (NYSE:LEH) , and now the GSEs are suffering a run on confidence.

The deleveraging of Wall Street is moving upstream to agency paper, the debt of the most highly leveraged financial institutions in the world. The GSEs were the model for the private market in complex securitizations like CDOs and even for hedge funds in terms of their use of leverage. As lesser private markets have imploded, pressure has been building on supposedly “AAA” issuers such as FRE and FNM — just as similar “AAA” ratings for securitizations came under scrutiny last year.

The GSEs were to the US economy what special purpose entities were to firms like Enron, Parmalat and Citigroup (NYSE:C). Bloated far beyond their historical role of merely acting as conduits for residential securitizing mortgages, FRE and and FNM operate at much higher leverage ratios than any bank or hedge fund and now have three basic business lines:

* A conduit for buying and securitizing qualifying mortgages as per federal housing law,

* An insurance unit that guarantees mortgage-backed securities, also in support of the housing mission; and

* A fixed income hedge fund operated for the benefit of FNM’s and FRE’s managers and private shareholders.

The announcement today by Treasury Secretary Hank Paulson that FNM and FRE might need access to the Fed’s discount window and/or infusions from the government itself is no surprise, part of the grudging process underway in Washington of facing the inevitable that must, in our view, lead to a re-nationalization of both housing GSEs.

Lest our conservative colleagues think we’ve taken a left turn, we see a federal takeover of FRN and FRE as not only inevitable, but as an avenue to rationalize and shrink these institutions, and thereby remove a costly distraction from the Washington political scene. A federal takeover is simply recognizing the extant economic reality that neither GSE can function without preferential – that is, near-sovereign – pricing for its debt.

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. Why members of the Washington political class ever decided to sell equity in the GSEs to the public is a topic we’ll leave to the historians. But suffice to say that with $90 billion in combined equity and six trillion in on and off-balance sheet footings, the enterprises are manifestly unsafe and unsound, and can only survive the yawning trough in real estate valuations that lies before us with unconditional sovereign backing.

If we were in the room with Ben and Hank, this is what we’d tell them:

First, the equity holders of the GSEs are dead men walkin, muerto. Whether you are talking about a private recap or a public takeover, the ersatz equity holders of the GSEs are toast. The debt holders and the US government are the true economic owners of the GSEs. Throw the shareholders a bone with a swap offer for debt, say ten cents on the dollar of book, and kill the public listing pronto.

The key issue facing the Treasury is how to reassure creditors and thereby get yield spreads for GSE paper to fall. To us, the way to end the crisis is to publicly recognize what Fed and Treasury officials have been telling officials of foreign governments and central banks for years, namely that FNM and FRE have the full backing of the US Treasury. This is not just a matter of new capital, as the Paulson proposal suggests, but a decision to retake control over two federally chartered corporations that exist at the sufferance of the Congress.

When you officially nationalize the GSEs, the chief constituency – namely the bond holders including many global central banks – are reassured. The crisis ends, the systemic threat goes away. Remember, FRE and FNM don’t need more capital – at least not immediately. But they do need access to the capital markets at preferential rates.

Once Treasury takes control of FRE and FNM, the two entities should be placed under OFHEO, merged and slowly shrunk down to the minimum size required to operate the two pieces of the business that actually support the housing mission, namely the conduit and the insurance book. Insurance rates should be allowed to rise to track private guarantee rates in an effort to dig the guarantee book out of its considerable deficit and offset the subsidy that must be provided by the Treasury. As with a zombie S&L, the sooner we act, the lower the cost of resolution.

Stabilizing FNM and FRE requires that Secretary Paulson confirm what we all know from the textbooks and from the business models of the GSEs; that they depend fundamentally on the financial support of the Treasury, not the support of private capital, to operate. If Paulson, who so far is a terrible disappointment as a master of the universe, does not soon get ahead of this situation, the Treasury’s ability to sell debt into the markets ultimately may be affected. Then all the proverbial bets are off.

Originally published at The Institutional Risk Analyst and reproduced here with the author’s permission.