How to Solve The GSE Crisis? Overview of Long-Term Solutions

On July 13, Treasury Secretary Henry Paulson announced his action plan with respect to the basically insolvent mortgage giants FannieMae and FreddieMac. The main points are the following:

- First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. The current credit line is capped at $2.25bn each.

- Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed

- The Federal Reserve Bank of New York has the authority to lend to Fannie Mae and Freddie Mac at the discount rate and against agency debt and Treasuries should such lending prove necessary.

As announced earlier, Secretary Paulson’s plan provides support to the GSEs 'in their current form', i.e. without formally nationalizing the institutions. At the same time, the full government backing of the GSE’s $5.3T of either owned or guaranteed debt is more explicit and aimed at supporting market sentiment. Similarly, shorting F&F shares has become less of a one-way bet once Treasury can step in anytime to support the equity price. The soon deteriorating market reaction after the announcement shows however that market participants are weary of letting the government have it both ways in the long run.

What could a viable long-term solution look like? Here’s a selection of proposals:

Nouriel Roubini: A bail-out of $5 trillion debt holders as outlined in Secretary Paulson’s plan is neither necessary, appropriate, nor desirable; it is indeed the worst of all worlds. A more cost-effective solution is to nationalize GSEs, give debtholders a 5% haircut considering the mostly prime quality mortgage portfolio, and assuming ultimate credit losses of ‘only’ $250bn according to the latest consensus estimates. OR leave face value intact and pay Treasury bill or bond interest rate on agency debt – this saves taxpayer $50bn annual subsidy to agency bond holder in the form of 100bp agency bond spread (100bp on $5T is $50bn.)

Joshua Rosner argues that the main culprit is F&F’s oversized investment portfolio at combined $1.6T compared to their very thin capital base resulting in a leverage ratio of around 50. At these leverage levels, even a small deterioration in the asset value of a basically prime quality portfolio leads immediately to insolvency. One possible solution is to bring the investment portfolios under ‘conservatorship’ and restructure the agency debt in such a way that current bondholders receive 90 cents on the dollar in senior debt and 10 cents on the dollar in subordinated debt (i.e. equity). This would help improve their capital position and allow them to operate again on a stand alone basis. In the future, F&F’s investment portfolio should be strictly limited to countercyclical liquidity provision purposes in the secondary RMBS market, not to build speculative positions as in the past.

William Ackman (Pershing Square Capital Management): In many respects similar to Joshua Rosner's plan, William Ackman proposes an action plan that would have: 1) Common and preferred equity wiped out; 2) Subordinated debt swapped for equity warrants; 3) Current senior unsecured debtholders get per each dollar of face 90 cents face amount of new debt and 10 cents face amount of new equity; 4) U.S. government provides a stand-by purchase commitment: Equity holders can put new common equity to the U.S. government at face value for the first three years.

Christopher Whalen of IRA Institutional Risk Analyst argues that the right thing to do is to nationalize F&F with a view to shrink both institutions. “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 these companies’ pursue explicitly a public goal, it makes no sense to run these companies for profit and as accountable to a limited set of shareholders.

James Hamilton: The idea of letting creditors bear the costs with a haircut as proposed by Nouriel Roubini is appealing at first. The overriding concern in dealing with the current mess, however, is that the process of rapid and radical deleveraging would so impede the flow of new credit that the housing price declines, foreclosures, and bankruptcies significantly overshoot the values that we'd expect in a properly functioning credit market. “My recommendation would therefore be for a managed bailout in which the stockholders, creditors and taxpayers jointly share the bill.”

Richard Iley (BNP Paribas): GSEs have become THE mortgage market since the onset of the financial crisis as private-label MBS issuance has practically shut down: Partial, or even wholesale, nationalization may be an answer although the recognition of $5.3T of owned or guaranteed liabilities would double the gross public debt with implications on the U.S. triple-A credit rating.