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A Closer Look at the Treasury's GSE Preferred Stock Purchase Plan

by: John Jansen September 07, 2008 | about stocks: FNM / FRE    

John Jansen

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In conjunction with the statement of Secretary Paulson, the Treasury has provided several fact sheets which flesh out the plan. I just read through the agreement which summarizes the Preferred Stock Purchase Agreement.

The Treasury will purchase Senior Preferred Shares of each entity and will begin with an initial purchase of $1billion. The preferred shares will carry a 10 percent coupon and pay a quarterly dividend. The Treasury will also receive warrants which represent going forward ownership of 79.9 percent of the companies. These contracts are for an indefinite duration and Treasury has pledged $100 billion for the effort. The fact sheet notes that that amount does not represent a judgment on the financial conditions of the companies but is meant to instill confidence.

In addition, if the FHFA determines that the liabilities of a firm exceeds its assets, the Treasury will make a capital infusion to the company . That amount of money will be additional preferred shares purchased by the Treasury.

New preferred shares issued will be senior to all other preferred and common shares.

GSE common and preferred shareholders will bear all losses ahead of taxpayers.

GSE retained portfolios shall not exceed $850 billion on December 31, 2009.

In the most striking provision of this section, Treasury has mandated that GSE portfolios will shrink 10 percent each year until they reach $250 billion.

That run off in credit risk will need to find a new home and will spark quite a political and economic debate going forward. One could argue that the private sector could assume some of that credit risk and should. I am sure that there will be also some who clamor for some new governmental entity to assume that risk. It will be a long debate and will be the major focus of whomever succeeds Paulson in January 2009.

I would add that if most of the credit risk is shifted to the private sector, there will be a painful adjustment period. The big investment banks have lost billions of dollars over the last year and transactions with large notional amounts will have management quivering for several more years.

The Treasury has also announced that it some time later this month it will commence  direct purchases of GSE credit guaranteed MBS. They can hold the securities to maturity, though they might adjust the portfolio if that is deemed appropriate.Treasury will have outside managers acting as its agent. The prime objective will to be to promote market stability and ensure mortgage availability and to protect the taxpayer.

Taxpayers should benefit from lower mortgage costs as well as from the positive return on the portfolio.

The statement from the Treasury says that the Budget impact will be minimal because the returns to the transactions should be positive over time.

The statement offers no hint as to how many mortgages the Treasury plans to buy. That initial decision will certainly have a budget impact as the Treasury will need to issue some debt to fund the initial purchases. So in the short run, issuance by the Treasury should increase.

The Treasury has established a short term lending facility for the GSEs which will be administered by the Federal Reserve Bank of New York. The loans will have terms of one week to one month and the rate will be Libor plus 50 basis points. All loans must be collateralized by mortgage backed securities issued by FNMA or Freddie Mac.

Market thoughts

I think that the Treasury has directly addressed the immediate problems which confronted the GSEs, which were uncertainty, ambiguity and lack of clarity regarding the relationship between the Treasury and the Agencies. The Treasury has illuminated that issue and there cannot be any question about where the Treasury stands regarding the debt of the agencies and the MBS which they issue. In that regard, there should be an enormous tightening of spreads between agency debt and Treasury debt in the next several trading sessions and the precision of the statement should bring foreign buyers back to purchase benchmark debt as well as the pass through securities.

Paulson has built a bridge to 2009. The heavy work and difficult work will fall to the new Administration. He has bought time, which was needed as much as an infusion of capital.

I think that credit spreads of every type will tighten. I think that the Treasury yields will do the brunt of the work. The 10 year Treasury has just completed a rally from 4.25 percent down to the middle 3.50s following the employment report on Friday. I would not be surprised to see that instrument revisit the 4.00 percent level.

Similarly the 2 year note had traded around 3.125 percent and on Friday morning it traded in the ether close to 2.10 percent. With the Federal Reserve on hold for several more months that is crazy. I would expect that the 2 year note will settle in somewhere between 2.75 percent and 3.00 percent. There is much fear priced into that instrument and as there is a return to normalcy the 2 year note should suffer inordinately.

Risk assets of every ilk should benefit and the greatly oversold stock market should rally dramatically.

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This article has 20 comments:

  •  
    Sep 07 02:03 PM
    well sounds more or less like the plan that Ackman presented on friday but the 'senior preferred shares' are stuck in between the books instead. This is a good time to privatized this socialist mess created by Democrats a long time ago.
    Reply
  •  
    Sep 07 02:25 PM
    Privitization a long time ago would mean that most of the mess we are looking at now would not have happened. The government used it's power over these two companies to polute their books for the sake of feeding Wallstreet's insatiable appitite for liquidity.

    I wonder why the news hasn't translated the double talk by Hank and company today into "what it really means to shareholders" language. Warrants are not stock, they are stock options that will dilute the stock value but at this point don't change the market price. There's no haircut because of the takeover today, so the market will be the ones seting the price come Monday.

    Buying preferred and buying MBS's at lower spreads actually infuses capital which will give the company breathing room. Explicite guarantees make GSE securities the safest on the market, which will also have the same effect.

    The real concern is what will this news do to the rest of the financials that don't have the same guarantee but do have bigger toxic waste problems. Why would investors buy anything from companies like LEH, WB, WM... if they have a better, safer option? Stand by for a crazy week in the financials. Friday will be considered relitively flat in comparison
    Reply
  •  
    Sep 07 02:26 PM
    This reminds me of Warren Buffett's story - when you are playing poker, if you don't know who the patsy is after 10 minutes, then you're the patsy.

    I listened to my Morgan Stanley broker and bought FNMA preferred last year, without really examining his contention that the company had an implicit government guarantee.

    When the preferred fell to 10 this August, I bought some more figuring that the government would not let all the US banks that owned preferreds fail - that they would save the banks now rather than saving them later (through the FDIC).

    Little did I realize that when it came to a showdown between US banks (preferred holders) and foreign central banks (debt holders), the foreign banks would win. The US can afford to let US banks fail, but cannot afford to alienate the foreigners who have been financing our government for the past decade or more.

    Bill Gross was smart enough to figure this out long before me. I was the patsy. Shucks. And I thought I was being smart by not investing in real estate. Turns out the Treasury is going to take my money and invest in a McMansion for me.

    Now what? The equity ticket-holders have been allowed to keep their ticket-stubs, in case FNMA emerges from this crisis with anything left. Common has been diluted 80%, but will probably be further diluted if the Treasury's exit strategy is a sale to private capital down the road.

    What is a preferred share worth without any dividends? Can I get some share certificates for my wall, or maybe on second thoughts, for my bathroom?

    Maybe it won't be so bad. There is $22 billion outstanding preferred, with dividend obligations of $1.7 billion. As I understand this plan, this will stand behind the Treasury's up to $100 billion in 10% senior preferred. If the full $100 billion is called upon, there probably won't be anything left to pay the ticket stub-holders. So this forces us shareholders to hope that the country's housing problems turn around, that the government can sell off non-performing assets, improve management and avoid dipping too deeply into the taxpayer's pocket. If the company emerges from conservatorship, shrunken yet profitable, with $30 billion or less in senior preferred, then the existing preferred (and possibly common) shareholders will get a decent return.

    But maybe I am just being a patsy again.

    In any event, we won't know for years. Any predictions for what will happen on Monday?
    Reply
  •  
    Sep 07 02:49 PM
    Patsy, if you used the same brilliance in investing that you used in constructing your post you would not be a loser. I quit listening to brokers years ago when I saw a midwest broker selling International Harvester bonds to unsuspecting farmers shortly before IH declared bankruptcy. As they say in the trade "they were moving the product". Yes sir, right off Edward Jone's balance sheet on to the farmer's and collecting commissions to boot.
    Reply
  •  
    Sep 07 03:06 PM
    are xlf 09/10 calls options good for this announcement since it seems to be created to stabilize the housing mtg market and improve capital liquidity?
    Reply
  •  
    Sep 07 03:09 PM
    You win some, you lose some. Take comfort that equity is not completely lost. Even at as 80% haircut of book value the intrinsically the equity is worth about $5 for fannie and $2 for Fred.

    Hopefully the housing market will stabilize now and the book value of the GSE will increase from here.

    This should have a positive impact on the broader market and will signal an end to the bear market.
    Reply
  •  
    Sep 07 04:14 PM
    Reducing the value of preferred and common to junk is appropriate, and probably understood by the last six months of investors, who have turned over this entire float at least three times. Maybe there are some institutions out there with $70 shares still on the books, but most retail folks are in these firms around $7-10 or so if they are still holding.

    There will be a stampede tomorrow by folks who'll bolt in either direction, first to think this is some kind of new guarentee, then those that read the fine print and find out, govt GSE preferred is WORSE than private banking preferred, a quote from Paulson, traditionally lost probably SEVENTY YEARS.

    After all, he just found out via JPM this is a "flawed model" and S and P took till conservatorship was announced to downgrade the stocks. Now that takes genius, doesn't it?

    The truth, the common and preferred will be all over the place.
    Reply
  •  
    Sep 07 04:16 PM
    Where I can find estimates of the absolute and relative amounts of GSE preferred, common, and debt that is held by various financial institutions?

    I'm a little surprised by Patsy's suggestion above that U.S. banks hold a lot of preferred stock relative to the size of their GSE debt holdings, and I'd like some pointers to research on this topic.

    Beyond that, I'll offer that it always seemed obvious to me that the govt's implicit guarantee for the GSE's would apply to the debt and the shares. I'd have a hard time imaging it otherwise no matter who were the holders of each type. But if it was actually true that banks currently hold a lot of preferred relative to their debt offerings that would be worrisome.
    Reply
  •  
    Sep 07 04:36 PM
    There's a web site that shows which institutions owns what and how much they traded each day, but I can't remember what it is.

    The banks and mutual funds hold large portions of both preferred and common both. They bought it up as a safe investment because of the implicit guarantee and high divi's, even with losses. Sovereign Bank holds $600 Million worth which will wipe them out if they lose it. Lots of mutuals bought in as a stable investment for their retired investors. Many of them have been hit hard.

    Common and preferred shareholders are going to bail at open which will further wipe out any value left in the GSE's. It's going to take $40 billion just to get back to Friday's levels, so don't look for any liquidity for the banks.

    Another great move by the Bush administration.
    Reply
  •  
    Sep 07 04:38 PM
    Oops, typo. I meant to write above that it always seemed obvious to me that the govt's implicit guarantee for the GSE's would apply to the debt and *not* the shares, or at least the debt in preference to the shares.
    Reply
  •  
    Sep 07 05:46 PM
    Sorry about the above.
    Here's my question: We're bailing out the GSE's to protect the bondholders, primarily but not exclusively Asian banks. And we're doing this, I assume, because we need to be able to continue borrowing money from the Asians and if we let the GSEs fail, then our borrowing costs will rise—a lot. But by taking the debt of the GSEs onto the government's balance sheet, isn't it almost certain, at least in the long term, to weaken the dollar? The Asians must see this and understand that we will repay the money we have borrowed with weakened currency. As a result they will demand a higher return. Isn't this just trading one problem for the same problem in a different form? In other words, borrowing money is going to get more expensive any way you slice it.
    Reply
  •  
    Sep 07 05:47 PM
    "In the most striking provision of this section, Treasury has mandated that GSE portfolios will shrink 10 percent each year until they reach $250 billion"

    I guess this reinforces the view that the GSEs kept the unsaleable toxic waste on their own balance sheets. At least now we'll get to see what prices they have to dump it for, although at $80 billion a year it will take them almost 8 years to get to $250 billion.
    Reply
  •  
    Sep 07 06:25 PM
    I have reviewed many of the articles and comments on SA and elsewhere with respect to the Treasury’s actions today. There appears to be a recurring theme that what they have done should put a floor under the housing market and eventually lift the broader market and economy out of its funk. The direct cost, while painfully high for the holders of common and preferred equity, would appear to be bargain for an action that holds such great promise. If it was that easy, wouldn't they have done it months ago, so what’s the catch? Or should I say what's the risk, are there any other shoes to drop?
    Reply
  •  
    Sep 07 06:46 PM
    deadwood, I believe we are "bailing out" the GSEs primarily to keep the spread between 10yr. T-bonds and mortgage backed securities from further widening, possibly by a lot, which would result in higher mortgage rates and even larger declines in home prices than what will otherwise occur, resulting in even more homeowner defaults and bankrupt financial institutions.

    What you point to I believe is a risk of doing this, that T-bond yields will rise and the U.S. currency will decline
    Reply
  •  
    Sep 07 07:31 PM
    my four puts for this are KEY, MFA, NCT, SOV

    E NUFF SED - why will this signal the end of the bear market?

    As I read some of the announcements, the growth in mortgage finance holdings will be limited to a $200 Billion increase before the inventory must decline by 10% per year.

    I think a large part of the increase limit will be soaked up by existing mortgage debt moving from the private sector banks to the GSEs, the actual purchase of newly initiated mortgages to clear the housing glut will be only a small part. Consequently, no healthy pickup of economic activity in the housing sector.

    Second, as stated above, common and preferred equity holders will see the market value of their holdings drop 20-40%. Since a sizable portion of the preferred is held by the likes of KEY, MFA, NCT, and SOV [the four I identified as have the highest percent of their holding in the GSEs], these banks will also take a hit [dangerously close to fatal for SOV]. So, this will be no help for the financial sector.

    Now tell me again, why this will signal the end of the bear market? What is going to be helped?

    Yes, the market may react tomorrow with a giant up-move, but at some point in the near future, the bear is going to re-assert itself.

    As for the preferential treatment being given the foreign banks; what good is their "safe" dollar-denominated debt instrument in a falling dollar market?

    In my mind, the real danger is a dollar-caused crash of the Chinese market/economy.

    JMHO
    Reply
  •  
    Sep 07 07:42 PM
    wow! the DOW futures have jumped from 27 to 232;
    should make for a good inverse/put entry
    Reply
  •  
    Sep 07 07:54 PM
    The Federal Reserve and other federal banking regulators said in a joint statement Sunday that "a limited number of smaller institutions" have significant holdings of common or preferred stock shares in Fannie and Freddie, and that regulators were "prepared to work with these institutions to develop capital-restoration plans." (translation - there is about $36 BILLION on banks balance sheet of PREFERRED shares - since the banks are in so much trouble we cannot let that fall or it will cause even more pain in our financial system = more of your tax dollars to make sure banks making private party investments are made whole. Repeat, your tax dollars will be used to make sure banks investments in Fannie and Freddie preferred is whole - enjoy)
    Reply
  •  
    Sep 07 08:36 PM
    An interesting August interview with ousted Freddie Mac CEO Dick Syron, not that he has much if any credibility but his comments about the economic conditions that would trigger an intervention went something to the effect that they would have to rival those of the depression (perhaps he was speaking on a personal level)



    Part 1 - www.cnbc.com/id/158402...


    Part 2 - www.cnbc.com/id/158402...
    Reply
  •  
    Sep 07 10:37 PM
    $36 Billion is NOTHING compared to the large picture here.
    Reply
  •  
    Sep 08 08:39 AM
    This is what is going on (vid below from 8/28th) . It's very obvious! Playbook begins at minute 3:00. This bailout is just another pump to have the banks delever a bit more before the collapse.

    Playbook:
    www.youtube.com/watch?...
    Reply
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