Reader, Charliein asks if the danger of the GSEs stem form their serving two masters (shareholders and the government). Charliein is absolutely correct! The GSEs were created to provided stability during economic disruptions and to encourage and stimulate home ownership. When they were created they did not serve two masters. They were government agencies. However, Congress came up with a great idea. Why burden the Federal budget with debt when we could have the private sector provide the funding and we will regulate them? Brilliant!
The GSEs issued five kinds of securities to raise capital. First are agency bonds. These have always carried the implied backing of the U.S. Government. Therefore, they offered fairly low rates for investors due to their safety. The GSEs MUST the use proceeds of these bonds to purchase mortgages from lending institutions. Proceeds cannot be used to repair damaged balance sheets. That is what subordinate bonds, preferreds and common equity are for.
The GSEs do not hold the majority of mortgages they purchase. They securitize them into Collateralized Mortgage Obligations or CMOs. These are bonds which get their cashflow from the repayment of the underlying mortgages. Although CMOs issued directly by banks are backed ONLY by the underlying mortgages. CMOs issued by the GSEs are backed by both the mortgages and the GSEs. If the underlying mortgages default (and they are over-collateralized), the GSEs will repay investors principal.
The three other securities have no implied backing. They are subordinate notes, preferreds and common equity. Although these securities have no implied government backing, many investors were willing to accept lower yields (or dividends in the cases of common and preferred) generated by these non-senior asset classes. The reasoning was that the government would not let the GSEs fail. No one ever considered "conservatorship" as being an option, including myself.
Now that we know the different kinds of securities issued by the GSEs, let's discuss how the GSEs got into this mess.
Being shareholder owned, GSE management had a legal obligation to maximize shareholder profits. However, as government sponsored enterprises who could borrow at low rates, Congress via regulator the Office of housing enterprise and oversight (Ofheo) has an obligation to oversee the GSEs to make sure they were managing risk properly and using sound business practices. The GSEs' predicament was the doings of both GSE management (common equity shareholders) and more so, Congress. Here is where the conflict lies.
The GSEs made substantial campaign contributions to the very lawmakers regulating them (Congress). As long as their balance sheets looked "OK" Congress left them alone. The GSEs ability to raise large amounts of capital at low rates permitted Congress to use the GSEs for their pet social projects. Have an area of the Country which needs cheap mortgage financing to encourgae home ownership (or for political payback). Freddie and Fannie mortgage standards could be changed for those areas only, to make those loans possible.
Since Congress was essentially being paid off and had free reign to use the GSEs to further its members social agendas, Congress turned a blind eye to some of the speculating GSE management undertook to increase profits. That is how we arrived at this point. The bailout was also politically-charged.
As the mortgage market began to collapse as borrowers went delinquent or defaulted on mortgages, the GSEs needed to raise capital to compensate for losses (note: it was not their core mortgages which blew up the GSEs, but subprime mortgages it wrote - some at the behest of Congress- and the subprime loans in which they invested).
Since the GSEs could not use AAA-rated agency bonds to repair their balance sheets, they had to use one of the other, aforementioned, vehicles. They couldn't issue subordinate debt as the market for it is limited and they needed Tier One Capital and sub debt is Tier Two (explanations of capital buckets and Basel II would require another discussion). The GSEs could have issued equity shares (and they have from time to time), but that would dilute shareholders further and, since teh equity dividend was already reduced to 5 cents per share, many investors would have stayed away in droves. That left preferreds.
Although technically a kind of equity (senior to common), preferred investors have no voting rights and trade (and usually treated as) long-duration, callable, very subordinate debt. Unlike common equity, investors (mostly banks, insurance companies, pension funds and mom & pop) looking for income. Since preferreds are callable at par ($25 or $50 depending on the issue), price appreciation is limited. The dividend is the attractive feature.
Due to mismanagement and poor oversight, Treasury secretary Paulson and his advisers determined that there was nothing left to do but to take over the GSEs (thanks in no small part to the urging foreign central banks who own billions of the senior debt and wanted an almost explicit guarantee).
If Mr. Paulson took over the GSEs, he had to preserve the senior notes (the reason for taking them over as they need to issue more to keep the mortgage market alive). He also had to proctect the subordinate note holders as, being debt, a default of subordinate debt would cause a technical default and a possible involuntary bankruptcy. Still, to appease politicians (mostly those who caused this mess, he had to sacrifice some investors to avoid criticism over bailing out investors at the expense of taxpayers.
The logical choice would have been common equity holders, but since they were down to 5 cents a share, the criticism would have come anyway. Mr. Paulson was adamant that the next senior class of investors, preferred holders, be wiped out along with common holders even though, like bond holders, were investing for income and had no vote or say in the running of the company.
The Government has done a marvelous spin job of saying how the punished Wall Street in favor of Main Street. However, this rings hollow when one considers that preferred holders consist largely of regional and local banks, pension funds and retired individuals. They blew up Main Street! To add insult too injury, the Government is paying itself 10% (higher than any outstanding preferred) on special GSE preferreds which only it can purchase. It would be cheaper for the GSEs to pay existing preferreds, even when lower bond borrowing costs (not much lower when one considers that treasury benchmarks may rise as much as credit spreads will narrow, negating the borrowing advantage).
Another side effect is that retail investors (the main players in the preferred market) will stay away from preferreds issued by banks. Although companies traditionally would not suspend preferred dividends unless facing bankruptcy, a precedent has been set and troubled banks may be more inclined to suspend common and preferred dividends if they are in trouble. Banks need to come with traditional non-cumulative preferreds to pad their Tier One capital ratios. Good luck doing that now. Feedback I have received from brokers is that they will in now way market preferreds to clients given what has happened to GSE preferreds. Now banks and brokerage firms will have difficulty raising necessary Tier One capital. Look for more trouble in the financial sector this Fall.
Although this post was quite lengthy, it is actually an abridged version of the story. Maybe tomorrow I will explain CDOs, CLOs and other exotic structures which helped blow up the economy.
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