19/08/2008

EUR/USD
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When Henry Met Fannie

There's no rest for a Treasury Secretary in a financial meltdown, as Hank Paulson is discovering. Fannie Mae and Freddie Mac continue to bleed mortgage losses, and so the Treasury chief may soon have no choice but to pull the trigger on his new authority for taxpayers to recapitalize the mortgage giants.

Fan and Fred shares took another header yesterday, in the wake of a Barron's article predicting that a Treasury recap was "almost inevitable." When a single story in one day can take nearly 22% off Fannie shares, and nearly 25% off Freddie's, you know investors are scared to death.

They should be. Two weeks ago the companies added another $3.1 billion in losses to the $11 billion they'd already reported in recent quarters. Both companies slashed their dividends and warned they'd buy fewer mortgages, while being more selective about those they do buy. So much for the assertion -- made so confidently this year by Barney Frank, Chris Dodd and Chuck Schumer -- that Fan and Fred would rescue the mortgage market from the housing slump.

Instead the companies have dug an even deeper hole than have many subprime lenders. Their current run of losses are based in so-called Alt-A loans, aka "liar loans," that didn't require enough proof of borrower net worth. Fan and Fred piled into Alt-A mortgages in recent years as a way to gain market share amid the late, unlamented housing mania. No one knows how many of those loans will go belly-up before the housing market starts to turn, presumably in 2009.

Both companies insist they have adequate capital to ride this out, but they also said this before Treasury and Congress felt obliged to make explicit what had been an implicit taxpayer guarantee. Freddie still says it will raise another $5.5 billion from investors, and good luck with that. Freddie has a negative corporate net worth and a market capitalization -- after Monday's losses -- below $3 billion. Freddie holders, who have lost more than 90% of their investment in the last 12 months, may not want to double down.

Meantime, Treasury claims it has no plans to inject taxpayer money directly into the companies. Even so, Mr. Paulson has quietly hired Morgan Stanley, the investment bank, to look into "appropriate capital structures" if he does decide to sign the blank check that Congress has given him.

Robert Scully, the Morgan banker who will lead the effort, is by all accounts a straight shooter. And he will need to be, given the enormous political pressure he will soon face from Fannie Mae's defenders, both at Morgan and in Washington. Morgan Stanley says it is forgoing any other investment banking business with Fan and Fred while it works for Treasury. But until recently it was among the banks advising Freddie on that elusive $5.5 billion capital infusion.

Morgan Stanley is also home to Kenneth Posner, one of the biggest Fan and Fred cheerleaders on Wall Street. Only last March, the analyst crowed about the "complete defeat" of the "anti-GSE ideologues" -- that is, the people who had been right all long about the reckless risks the companies were taking. Mr. Posner also predicted that Fannie and Freddie would return to breakeven by the third quarter. Mr. Scully shouldn't be caught in the same intellectual area code as Mr. Posner.

A taxpayer recap for Fan and Fred would be far different than most Wall Street deals. Typically, the banker's job is to balance the competing interests of the existing shareholders with the need to raise money at a price the market will bear. That can't be the priority here. If taxpayers have to ante up, the only justification is to protect the larger financial system. Existing Fannie and Freddie shareholders should be wiped out and managers and directors lose their jobs. We think Mr. Paulson should already have eliminated managers and private holders as a price of the recent bailout legislation. But if he lets either survive after taxpayers are forced to inject cash, the Treasury chief should be run out of town.

The new law also creates a new regulator for Fannie and Freddie, and the nominee for that job hasn't yet been named. The current acting director of the newly created Federal Housing Finance Agency, Jim Lockhart, has done a capable job with the limited tools available to him and would be a fine choice. But the Bush Administration needs to act now so the Senate can vote to confirm someone in September -- not wait six months or a year hoping that the crisis will go away.

A taxpayer recap for Fan and Fred can't be a get-out-of-bankruptcy-free card. As a de facto nationalization, any plan should rein in their riskiest operations with a goal of selling their profit-making businesses to the private sector, and perhaps handing what's left of their "affordable housing" mission back to Housing and Urban Development. It's time Mr. Paulson put taxpayers ahead of Wall Street.