Sunday, September 7, 2008

Roubini rants about the GSE bailout

Here are his ten reasons why he's ticked.

"First, common shareholders instead of being fully wiped out –as they do deserve – will only be diluted and hold about 20% ownership of the GSEs. There is no justification for this even partial bailout of the common shareholders as the two GSEs are insolvent.

Second, the government will inject capital – possibly and eventually hundreds of billions of dollars – in the form of preferred shared, not common shares. So instead of wiping out current shareholders that deserve to lose their entire capital such shareholders will be still technically speaking the owners of these firms. And the fiscal cost of this bailout will be very expensive: we estimated in June that the eventual losses for the government from this bailout could be as high as $200 to $300 billion, an estimate that is now shared by former Fed Governor William Poole. This is a huge figure on top of the other trillion dollar plus of fiscal costs of bailing out the financial system that will occur once the current systemic financial and banking crisis takes its full toll.

Third, the current preferred shareholders will not be fully wiped out –as they should be – and it is not even obvious whether they will take any haircut on their preferred shares; so they may be bailed out too. The government decided not to fully whack the preferred shareholders as this group includes many smaller and regional banks and insurance companies. But this additional bailout action exacerbates moral hazard and the fiscal cost of the bailout of the two GSEs.

Fourth, the subordinated debt holders and the unsecured debt holder will not be subject to a haircut. Thus, since preferred shareholders are second in absorbing losses (after common shareholders) the preferred shares of the government are junior to such debt holders.

Fifth, while not hitting the unsecured debt holders may have made some sense (as a lot of the agency debt is held by foreign central banks, sovereign wealth funds and other investors who would have fled the agency market if they had been subject to a haircut) not touching the subordinated debt of the GSE makes no sense; that is another additional bailout of a category of agency creditors that adds to the fiscal cost of the bailout.

Sixth, a number of authors including myself, Bill Ackman and Josh Rosner had argued that the proper way to recapitalize (and reduce the excessively high debt to equity ratio of) Fannie and Freddie and put them on sound and sustainable long run footing was to hit the agency debt holders with a haircut and convert part of the agency debt into equity. Instead having the government injecting capital in the GSE (as the Treasury plan does) does not resolve the problem that these are zombie giant institutions that are currently not viable and that need to drastically changed and scaled down to reduce their systemic risk and allow them to provide appropriate services to the mortgage market.

Seventh, the government plan includes the provision of credit lines – of an amount that is not specified but is potentially as high the Treasury wants – to Fannie and Freddie and to the other 12 FHLBs. The Treasury statement does not clarify whether these credit lines will be senior to other subordinated and unsecured agency debt or not. Since this provision of credit is a form of debtor in possession financing – like IMF lending to countries under distress – it should be de jure senior to the debt issued by the GSEs; it should also be senior to the mortgage claims that the GSEs have guaranteed. Instead, the Treasury’s silence about this matter suggests that these credit lines will not have any seniority compared to the unsecured debt of the GSEs.

Eighth: Treasury will purchase mortgage-backed debt issued by the GSEs in the open market. This is another form of government intervention and manipulation of the MBS market that is totally unwarranted.

Ninth, the GSEs will increase their MBS portfolios through the end of 2009 as a way to prop the mortgage market. In order to limit the moral hazard from this action that further increases the size and roles of the GSE the Treasury plan claims that the GSEs will reduce by 10% a year their portfolios from 2010 on. However, the short term increase in the portfolio of the GSEs is reckless and a further waste of taxpayers’ money. The problems of the GSEs mounted as they increased their activities and portfolios; and the decision earlier this year to increase their portfolios, reduce their capital requirements and increase the limit for conforming loans accelerated the demise of Fannie and Freddie. Thus, for the government to now say that their portfolios will be further expanded until 2009 is to add insult to injury. Their portfolios should have been reduced years ago and should be reduced now; it should not be reduced – a wishful statement with little substance as it can be reversed any time in the future – two years from now.

Tenth, the Treasury plans says nothing about how the two GSEs will be eventually restructured, downsized, split into smaller institutions that are truly private, competitive, not sources of systemic risk and not a further drain on the taxpayers’ money. This plan does nothing to restore the long term viability and efficiency of such institutions. It is just a very expensive taxpayers’ funded bailout of the shareholders and creditors of these institutions. Like the action taken in the Bear Stearns case and other recent government interventions and bailouts of private and quasi private financial institutions this is a form of privatization of profits and socialization of losses; it is socialism and corporate welfare for the rich, well connected and Wall Street."

It's really not about moral hazard. It's about his bearish friends who were short debt and CDS whose bets are now going sour.

He pontificates on moral hazard, and rants that people were bailed out. A housing plan helps homeowners and families. Does that concern him?

The bailout of the GSE's will not allow his predictions of a housing depression to be taken seriously. Maybe he loved the limelight of the press who appreciated his cerebral viewpoint.

Now he's cerebral but wrong.

Maybe that's the "moral hazard" he's overlooking!

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