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Help for the GSEs and Housing
By: Dr. Charles Lieberman
Date: 9/8/2008
Treasury's placement of the GSEs under conservatorship is intended to improve the supply of mortgage credit to the housing market to promote an economic recovery. This was implemented in a way that minimized the damage to the preferred stock market and the banking system. In fact, Treasury did not wipe out either the common or preferred stockholders of the GSEs as the market feared and both may recover in time. Most importantly, mortgage credit terms should improve, which is necessary for the housing market and economic growth to pick up. Given difficult circumstances, Treasury appears to have done a good job of balancing conflicting needs.
Treasury will be supplying plenty of capital to the mortgage market. The amount stated was up to $100 billion to each GSE, an amount large enough to make the point that investors should not doubt that the debt of the GSEs will be well protected. Treasury will own both senior preferred stock and mortgages guaranteed by the GSEs. In both cases, GSE common and preferred equity will suffer any losses before the Treasury loses a dime. If the GSEs dont suffer credit losses that exceed roughly $100 billion, In fact, Treasury could make billions of dollars by this backstop to the GSEs. Treasury will earn 10% on the senior preferred, and pay less than 4% on its own debt, thereby earning a spread of more than 6%, worth $60 million for each $1 billion invested. Treasury will also earn a commitment fee for its explicit guarantee of GSE debt. Most importantly, these steps should assure a generous supply of credit to the mortgage market, which should help in the recovery in the housing. In principle, credit availability should no longer be an issue in mortgages. In practice, this could also improve credit availability more widely.
Contrary to market expectations, Treasury did not wipe out the common shares of the GSEs, choosing instead to dilute shareholders by about 80%. Investors also worried that preferred stockholders would get wiped out. Instead, Treasury merely ceased dividend payments for some undetermined period. Why didn't Treasury inflict far greater damage? Most likely it held back because Treasury needs to use the GSEs to funnel more credit to the mortgage market and couldn't easily justify pushing into bankruptcy two companies that can claim to be well capitalized on a GAAP basis. So why did Treasury act at all? First, investors have been shying away from GSE debt, increasing the risk of a credit meltdown. Second, Treasury needs to increase credit availability to the mortgage market to promote a housing recovery. The GSEs, however, need to husband capital, which they can do by refraining from new lending. Thus, the interests of Treasury and the GSEs were not aligned. Under the conservatorship, Treasury can provide the capital that the GSEs lack and use the GSE structure to provide increased liquidity to the mortgage market.
Foreign and bank ownership of the GSE preferred or common shares was not much of a factor. Treasury indicated it would work with any adversely affected bank to help them raise more capital, if necessary.
The implications of these developments for investors are reasonably straightforward. The liabilities of the GSEs are now as good as Treasuries and the risk premiums on these bonds should narrow sharply. The preferred stocks can be evaluated as the equivalent of zero coupon securities with an unknown period before they resume dividend payments. Their value will reflect the market's judgment of how long before dividend payments resume. The common shares, like those of MBIA or Ambac, will have a value that depends on the performance of the mortgage portfolio that will take some years to evaluate fully. For the economy and the equity market, the financial issues of the GSEs are now history. Now, investors will focus on the Treasury's ability to supply as much capital as it chooses to the mortgage market to help promote a housing recovery. This will be very helpful to the housing market, the economy, and all financial firms and improves the near-term prospects for the economy. The decline in new housing construction is already reducing excess inventories rapidly. Now, credit availability will not inhibit that recovery.
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