Treasury Policy is Close, but Ten Percent is not a Real Penalty Rate

Treasury is very close to getting the incentive right in the Fannie and Freddie bailout. Despite Congress’ unwillingness to act, Treasury shut down GSE lobbying, took control, removed private shareholder dividends, and injected capital rather than debt. They did not however, extract a penalty rate on the Treasury senior preferred stock. Recall, recent recapitalizations have carried a stated 12%-14% rate of interest, and priced in the market to yield 20%-24%.

While many might think that an inconsequential shortcoming, the rate in tandem with remaining shareholder votes provides the natural exit mechanism. Here, with a low rate and no shareholder vote, we are relying crucially on Congress to craft the exit. It is important to realize, however, that Paulson is right in maintaining that the exit needs Congress’ attention – a conscious decision and vote on nationalization or privatization. In the meantime, Treasury has set the stage for a de facto nationalized set of GSE’s, which, again, is probably the best he can to do stabilize mortgage supply in the short term.

The other policy shortcoming here is the conditions behind shrinking the portfolios. With the natural exit strategy outlined above, shrinkage happens organically, dictated by market conditions. Here, political battles will be fought in 2009-10 about the need or the GSE’s to continue to support mortgage supply. Furthermore, the requirement of shrinkage or a portfolio target of $250 billion is specious in a world of “off-balance sheet” accounting, securitization, and financial engineering.

Hence, the short-term fix – while arguably necessary – will not restart mortgage markets. The plan merely replaces the market with a taxpayer-funded mortgage finance mechanism. That stopgap mechanism, however, leaves the system open to crony capitalism wherein the industry will continue to appeal to Congress for handouts. With Merrill, Lehman, Wachovia, and WAMU (to name a few) still facing substantial financial difficulties, Congress needs to put limits on the extent of bailout programs now – not after the elections – to stem further losses.

We are still fighting the symptoms rather than the disease. Look to Thursday’s Senate Banking Committee Hearings on FASB reform will, hopefully, shine light on the disease and the proper way forward.