Jewish World Review Sept. 10, 2008 / 10 Elul 5768

Paulson didn't bailout Fannie and Freddie --- the power grab was thievery, Mafioso style

By Robert Robb

http://www.JewishWorldReview.com | Less than two months ago, Treasury Secretary Hank Paulson told Congress and the country that if he were given virtually unlimited power to intervene in the affairs of Fannie Mae and Freddie Mac he wouldn't have to use it.

"If you have a bazooka in your pocket and people know it, you probably won't have to use it," was the inartful way he put it.

Well, Paulson was massively wrong, and remarkably quickly so. Worse, the powers that Paulson successfully sought, rather than calming markets, alarmed them further.

Fannie and Freddie do not originate mortgages. Instead, they buy mortgages, bundle them into securities, guarantee their performance and sell them to investors. This frees up funds from the mortgage originators to continue lending. They also hold some of the mortgages they bundle and buy mortgage-backed securities from others for investment.

Fannie and Freddie have to raise capital to buy mortgages. The threat of federal intervention severely hampered their ability to do so. If there were a federal intervention, no one knew what would happen to existing shareholders and debt holders.

The seizure of the two companies orchestrated by Paulson over the weekend wasn't a bailout. The management of Fannie and Freddie were still trying to make things work despite the added burden of the uncertainty created by the bazooka in Paulson's pocket.

Paulson concluded that they weren't going to make it. He decided that the federal government was going to take them over.

So, the federal government put the companies into conservatorship. It also awarded itself, for both Fannie and Freddie, a billion dollars in equity with a guaranteed rate of return of 10 percent and the right to purchase, at terms it sets, up to about 80 percent of the company.

This wasn't even a takeover. It was thievery, Mafioso style.

In the modern world of global finance, Fannie and Freddie should not exist. They are anachronisms. And they may not have made it.

But they deserved the chance to try, rather than being given a choice they could not refuse by Godfather Paulson: accept conservatorship and preserve some position for your shareholders or be involuntarily taken over with shareholder equity being perhaps totally extinguished.

Paulson has asserted and seized a remarkable degree of authority over private economic activity. He also forced the fire sale of Bear Sterns to J.P. Morgan Chase. He even dictated the price of the transaction.

In the process, he has put taxpayers at risk for hundreds of billions of dollars in mortgage financing. Fed chairman Ben Bernanke has willingly allowed Paulson to use the Federal Reserve as a piggy bank for his power grabs. As a result, half of the Fed's assets now consistent of junk other investors are shunning.

This is all supposedly to prevent systemic financial risk. This is the theory that if one big boy fails, all the big boys will fail.

In Fannie and Freddie's case, the consequences of their failure and their indispensability to mortgage finance are both exaggerated.

The mortgage-backed securities Fannie and Freddie guarantee are mostly held by others. The underwriting on the underlying mortgages was pretty sound.

The delinquency rate on them is just around 2 percent.

So, if the guarantees became doubtful, the market value of the securities would decline, but not by much.

And there are other ways of creating a secondary market in mortgages. In fact, the existence of Fannie and Freddie, with their substantial competitive advantage from a perceived (now explicit) governmental guarantee, hampered the development in this country of the covered bond approach that predominates in Europe.

With covered bonds, the mortgage originator keeps the mortgage. The originator then issues its own bonds backed by its mortgages, replenishing its capital to keep lending. But because the originator is on the hook for any defaults on the underlying mortgages, underwriting tends to be tighter. Paulson, in addition to riding roughshod over the private economy, is really trying to continue pumping money into housing when the market is screaming, about as loudly as it can, that there's been an overinvestment in housing.

President Bush's previous treasury secretaries — Paul O'Neill and John Snow — were thought to be mostly ineffectual. The country didn't know how well it had it when Bush's treasury secretaries were merely ineffectual, rather than perniciously effective.