In a capitalist world losers take losses and winners gain. Well, that was the world we lived in previously. Now equity holders, who are supposed to be wiped out in an insolvency are not allowed to fail and debt holders in private companies are insured by the government.
Instead of protecting those who made bad bets it would make more sense to use our existing rule of law to address the situation. That should mean that we allow weak players to fail and organize the orderly transfer of good assets from weak hands to strong hands. The Government can keep using misdirection to put the burden on the taxpayer by citing “financial stability”. Should the obligation lie with the taxpayers or should it remain with bad risk managers and be wound down in an orderly manner? One thing is for sure, the Government you have elected is inoperative.
Below is an idea that I believe would have been more prudent and would not increase moral hazard.
Prepackaged bankruptcy / reorganization plan:
1- MBS Debt ($3.5 trillion): Why not give OFHEO or the new regulator a large line of credit <$500 billion> (just as the FDIC has $30 billion) that can be used to assure MBS holders their timely payments. Over time that line will be repaid to Treasury by the running off of the portfolios, natural foreclosures, and PMI. The GSE MBS will likely incur little loss over time as these debts are backed by real assets and little leverage.
2 – Senior debt of the Companies ($1.5 trillion): Senior debt holders had always understood that all offering circulars, risk weighted capital documents, etc. stated clearly that the debt was not backed by the Federal Government. These holders should, in exchange for their current debt, receive $.90 cents of new long dated senior debt in the reorganized Company and $.10 of new subordinated debt. This would effectively result in the Companies having enough capital (about $150 billion of new capital) to genuinely deserve AAA ratings on a stand alone basis. The new capital should be used solely in support of their core chartered mission. Here is where the bulk of losses ultimately will come from. It is where the leverage is, where the speculation is and where the weakest assets are.
3 – The Government should require that on a going forward basis the Companies should have minimal portfolios and they should be solely for liquidity purposes.
4 – This approach would allow them to, with a well capitalized balance sheet, meet their social mission.
Every day they are allowed to issue more corp debt they are growing their moral hazard position, the Government proposal of 6pm fuels that risk taking. Every time the Government allows investors to believe they will bail out the senior debt holders it becomes harder for them to do otherwise and take the right, confidence building, moral hazard reducing thing.
2 Responses to “How to Fix the Fannie and Freddie Insolvency without a Government Bailout”
It’s a workable plan. Since this is an election year, watch it not be enacted.
This is one of the better ideas. The notes must be the most pressing problem, especially since further stress on the housing market will have the effect of reducing (ignoring new production) the contingent liabilities (MBS guarantees) and icreasing assets (mortgages, foreclosures), the main funding source (ignoring Federal Reserve borrowing) for which is notes.But the demand for notes is likely to diminish..I think that a combination of (a) haircuts (or perhaps accounting wise less punishing forms of debt relief) (b) ringfencing fresh foreclosures and financing that portfolio with a special class of US treasury paper (unfortunately), access monitored by a new agency and (c) creating a third, credibly uninsured, also ring fenced portfolio funded by a mixture of stock and debt, and overseen by the banking supervisor, perhaps qualifying for an FDIC like guarantee program. I see a role for foreign official holders of GSE debt, as haircut recipients (subordinated paper, preferred stock, or even fresh common) and de novo strategic investors (SWFs), in (a) and (c) . Many countries currently investing in agencies have an ongoing interest in continued supply of quasi official US paper.Then there is the problem of MBS guarantees. I would suggest that the federal government (either directly or by expanding the GNMA charter) undertakes to guarantee a high portion (say 80%) of any loss the GSE’s suffer on mortgages that conform to strictly maintained federal standards, to be reset once a year by congress for at lest the next five years. The cost to the taxpayer of such a program should be minimal, especially if this succeeds in making the housing market more liquid (the part of the problem whose solution has enormous positive externalities) which would make it more acceptable to deal with the burden of insolvency (the part that can only be solved by higher personal incomes and that will take time or irresponsible macroeconomic policy). )Needless to say that there should be sacrifices among the ranks of senior mnagement (in both the GSEs and the government regulators, as well haircuts for large shareholders without employee (non-management) status. Apply yje Enron lessons..