Housing Doom

Treasury Secretary Henry Paulson today outlined his plan for shoring up Fannie and Freddie:

First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

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.

Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer. Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.

He also stated:

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Perhaps the Treasury Department has decided that desperate times call for desperate measures: [Hat tip to John and Mr. Twist!]

Treasury Department officials were working the telephones yesterday to make sure that Freddie Mac, one of the nation’s two troubled mortgage giants, will be able to sell $3 billion of its securities tomorrow in a previously scheduled sale that has now become a crucial test of investor confidence.

Though officials said they were optimistic the sale would be a success, anything less would pose new questions about how far the federal government is willing to go to prop up Freddie Mac, its sister Fannie Mae and other faltering financial enterprises.

Officials spoke yesterday with major banks that normally purchase securities, like the short-term debt offered by Freddie, to ensure these firms still plan to place bids tomorrow. This was part of an effort by officials at Treasury, the Federal Reserve and other agencies this weekend to gauge market sentiment and check that investors still have faith in Freddie Mac and Fannie Mae after the steep decline in their stock prices last week.

At the same time, Treasury officials were considering several options to backstop the sale in case they discover that interest in the securities is flagging, according to sources familiar with the discussions. Under one alternative, the Treasury or Fed would purchase the securities directly.

Other possibilities are allowing the Federal Reserve Bank of New York to buy the debt indirectly through private brokers or asking private firms to purchase the debt while extending to them either a public or private assurance that the government would back the securities if Freddie were ultimately unable to cover its obligations.

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Doom’s own John has been a long time commenter on the "Safety Net That Never Was"- the government’s implicit guarantee of Fannie Mae and Freddie Mac.  John started writing a series of posts for us back in the summer of 2006, and I’m going to get around to reposting some of them- I think Doomers will find the John was amazingly prescient.  I always thought that John’s posts were ahead of their time– most people seemed to think at the time that the thought of the GSEs failing was absolutely ludicrous.

The following is actually not a post, but John’s response [Scroll down to #4] on GSE’s capital problems to a Bill Maloni post last August. [Bill Maloni is a former GSE insider.]

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Conforming mortgages are too safe.

Think of a river flooding. Sally Submariner’s house lies low by the water’s edge, Allen Altman’s is only slightly higher, while Peter Primus’ is a fair bit up the bank. Pete’s in a less risky position, but should the river ever get up to his level, he’ll go to the emergency shelter only to find that Al & Sal have taken all the available beds.

Or think about the three little pigs. If, heaven forbid, the Wolf were ever to put a dent in the Third Pig’s house, he’d apply to Hillary’s fund only to find the money long gone on sticks and straw.

Now Fannie Mae’s $700-odd billion retained portfolio features a witch’s brew of leverage and risk management, the latter having turned to custard as evidenced by some Quant noting last week that his sector has become correlated since about the first of this month. What Fannie did to leverage their portfolio during the Tim Howard era was they sold nearly all of it to counterparties in such a way that Fannie retained much of those mortgages’ profits (so it’s still there in a real sense), but it’s no longer on the balance sheet, so Fannie has to keep way less capital around in case of trouble. Tanta sketched out how these deals work in a post one week ago titled “SFAS 140: Like A Bridge Over Troubled Bong Water”.

It’s leverage because the decreased capital effect (fewer mouths to feed) is more significant for Fannie’s shareholders than what they give up to the portfolio’s buyers for taking on the risk. That is, if there’s a loss in the portfolio, it’s covered by the counter-parties’ capital. But with less risk, there are many fewer stockholders to share out modestly less income, so it’s a big win for them.

Now for the risk management to work, Fannie’s managers will seek contractual assurances that their counter-parties are themselves excellent risk managers with uncorrelated, diversified portfolios — hello, hedgies. And the portfolio is really good stuff, so Fannie has likely diversified themselves by selling these great assets to just about everyone.

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From CNN yesterday evening:

NEW YORK (CNNMoney.com) — In what could turn out to be the most expensive bank failure ever, troubled mortgage lender IndyMac Bancorp Inc. was taken over by federal regulators on Friday.

The operations of the Pasadena, Calif.-based thrift - once one of the nation’s largest home lenders - were shut down at 3 p.m. PDT by the Office of Thrift Supervision and transferred to the Federal Deposit Insurance Corp.

About 95% of the $19 billion in deposits in the bank are insured, but that leaves $1 billion that was not covered by FDIC guarantees. According to the agency, 10,000 IndyMac customers could lose as much as half of that amount, or $500 million. The agency says the failure will cost the Deposit Insurance Fund between $4 billion and $8 billion, based on preliminary estimates.

I was wondering what kind of dent a hit of between $4 billion to $8 billion was liable to make to their reserves.  According to the FDIC’s website: [This page last updated 5/22/06]

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