A Hedge Fund manager with a decent idea

Freddie and Fannie were two Americans most Australians never knew existed until recently. Freddie and Fannie are two large US institutions that perform the function primarily of selling mortgage insurance against US housing mortgages. They do other things (see Wiki)

Fred and Fannie are very highly leveraged. In fact it ought to be a criminal offense for anyone to be leveraged at 140:1 (debt to common stock) :-). They could only get to be so large because there was always an implicit US government guarantee supporting this caper. Invaribly, when moral hazard comes into the picture, it usually ends in tears. The reason it’s ending in tears is the state of the US housing market has essentially rendered these two insolvent. Insolvency could mean US$5 trillion which would be the big enchilada of all time.

Enter Bill Ackman a well-known Hedge Fund manager who’s come up with what seems to be a truly brilliant proposal to save the US taxpayer a lot of money, keep these two institutions solvent and finally allow the US government to remove its implicit guarantee. The proposal, if it goes through, would probably cost the US government nothing and allow the two newly well-capitalized institutions to continue doing what they do, which is to insure mortgages in a far more conservative real estate market environment.

Ackman’s plan is as follows:

1. Wipe out the common shareholder, as there was never an implicit guarantee to protect capital.

2. Offer the junior debt holders a warrant against the much riskier debt. It could well be argued the riskier debt never carried an implicit guarantee (such as junior debt).

(This is where it really gets interesting. The senior debt holders…)

3. Break up the senior debt into two components. 85% -90% would remain as is (senior debt) while the 10%-15% would be taken as equity. The equity component would carry a US government buy-back (put) for 3 years at the face value. This means that any holder could go and redeem the equity component from the US government at 100 cents in the dollar.

This achieves several things. It allows Freddie and Fannie to stay in business with well-capitalized balance sheets.  New equity would reduce leverage to about 10:1 and essentially recapitalize the two institutions allowing them to stay in business writing new loan insurance in a more conservative environment. More importantly it would allow the government to remove the implicit guarantee for all time.

Once the market understood the US government is there for three years guaranteeing the equity portion the price of the equity coupon would probably rise above the face value and allow the US government to avoid having to fork over any money at all.

The overall effect is that it could stabilize the US housing market.

It’s a very elegant scheme.

One other thing:

A few Australian journalists were suggesting we introduce a similar deal in our market when our rates tightened. The potential default in the US of 50% of US GDP should shut them up for ever.

17 thoughts on “A Hedge Fund manager with a decent idea

  1. Perhaps when the US government becomes insolvent we can all swap debt for equity and own a piece of the US government. 🙂

    Seriously though the proposal doesn’t look terribly different to the sort of thing that administrators of insolvent companies do all the time. They wipe out the old shareholders. They recapitalise the company. The alternative is usually liquidation (ie sell the assets). However with a company that primarily holds financial assets that are an aggregation of many relatively small contracts the path of recapitalisation is probably far simpler. The novelty in this case is in extricating the government from a very ugly position and in using some short term bonds to prop up confidence.

    Along side shareholders the directors and senior managers of Fannie and Freddie should all fall on their swords. And the federal reserve should be abolished just to be sure.

    My bet is that the US government does something stupid instead.

  2. “In fact it ought to be a criminal offense for anyone to be leveraged at 140:1”

    I disagree with that. If things are transparent, then it is the lenders fault for taking too much risk. If the reason these companies in particular got there is because of the government (versus private investors), then it is a pretty clear indication of what government’s shouldn’t do.

  3. JC, why do you believe it is acceptable to put the shareholders to the sword while saving the creditors? I know that’s usually how it’s done, but what is the reasoning?

    If the creditors invested in something that was a pack of cards, how does that make them different from equity investors?

    An alternative might be to value the assets, apportion the value to the equity and debt holders equally, give a time-limited government guarantee to backstop the value, and then get out of the way.

  4. Seriously though the proposal doesn’t look terribly different to the sort of thing that administrators of insolvent companies do all the time.

    Sure it does… in terms of having a put to sell the equity portion back to the government. That’s pretty novel and if it isn’t you could perhaps show otherwise.

    Conrad:

    I was joking about that. Did you notice the :-)?

    The point is that only a government organization could make it’s way to having a debt/equity ratio of 145:1 and pretend sanity.

    David:

    there was never any undertaking (as part of the”guarantee”) that the shareholders be covered. They’re dead meat who knew the risks.

    There was always an implicit guarantee the US government would stand behind the twins for debt senior holders. They never suggested otherwise and the debt always traded as though it did. The Feds therefore have a responsibility.

  5. JC – I said that their was novelty in the put option. However other than that it is not that amazing a proposition. Of course amazing is in the eye of the beholder I suppose.

    David your point is a fair one. Creditors should risk losing their money if they deposit their funds with a dodgy bank or even with a good bank that goes south. However I seem to recall in the Bears Stern discussion that it was you suggesting that government intervention was probably reasonable in proping up the financial sector.

    https://alsblog.wordpress.com/2008/03/16/fed-bails-out-bear-stearns/

    See comments #41 onwards.

  6. JC – I said that their was novelty in the put option. However other than that it is not that amazing a proposition.

    the put is an excellent concept, Terje. Even US treasury officials were intrigued. I didn’t call it “amazing”. I called it brilliant and elegant which it is.

    But as I said, you could show us a better idea or example.

    David your point is a fair one. Creditors should risk losing their money if they deposit their funds with a dodgy bank or even with a good bank that goes south.

    Not when they were implicitly offering a guarantee for 70 odd years, they’re not. The US were more than aware of the effect of the guarantee by remaining silent when the twins were borrowing at narrower spread to US treasuries than other comparable borrowers.

    They cooked their soup when it came to the twins, now let them eat it as it teaches the bastards a good lesson for future intervention.

  7. JC — the only way to get rid of the implicit guarantee is to let the creditors lose their money.

    It doesn’t hurt politicians to have them “eat their own soup”, because they do it with taxpayer money. And while it is unfair that the creditors lose money, it is even more unfair that taxpayers lose money. They had nothing to do with this.

  8. David – creditors don’t always have to be protected but in Fannie and Freddie’s case, they do. The US govt always provided a ‘nudge and a wink’ guarantee to bondholders – it is inconceivable to allow these bonds to default.

    Terje – i still believe the Treasury did the right thing by bailing out Bear (as in this case, systemic risk > moral hazard). However, my Wall St friends are only now waking up to the implications of this action – much more regulation of Wall St by elected officials and a lot of leaning on Wall St to lower bonuses (i.e. “you’re only in business because of our guarantee, so cut the bonus pool by 80% as its outraging our recession-bombed electorate”).

    Also Bear was a wake up call to the industry to spread its counter-party risk much more widely – this it has now done. In other words, everyone is now prepared for a Lehman Chapter 11 and the Fed would not be required to intervene.

  9. Everybody always talks about being responsible just after the disaster. Lets see how behaviour is in 5 years time. My guess is that nothing has really changed. However if it has then that makes now an even better time to close down the fed.

  10. JC — the only way to get rid of the implicit guarantee is to let the creditors lose their money.

    I have to disagree, John. I don’t think the US can morally walk away from the twins seeing there was always that guarantee. That’s just not right.

    It doesn’t hurt politicians to have them “eat their own soup”, because they do it with taxpayer money. And while it is unfair that the creditors lose money, it is even more unfair that taxpayers lose money. They had nothing to do with this.

    Well the taxpayers did have something to do with this. They were complicit in allowing that corrupt caper to go on. You just can’t divorce the politicians from the public,as they are their elected representatives. They loved the socialization of lending practices because they got “good” deals and now it’s coming home to roost big time.

  11. Terje:

    Try 10 years time. The 80’s and 90’s S&L fiasco /real estate downturn was about a $200 billion problem in early 90’s dollars (which is about 370 billion in 08 dollars). It took about 7 years for that problem to work itself through the system. They also had the tailwind wind of he peace dividend in the 90’s.

    This is about $500 bill problem now and could reach anywhere from $1 to $2 trillion.

    I would say it will take at least 10 years before we see the end of this.

    The US economy is badly wounded. It has two wars it’s fighting. There’s a third war too if we take domestic security into account. There’s oil at 140 bucks a barrel and there’s the banking and real estate crisis. on the other hand these are all headwinds.

    I hate making predictions but I can’t really see any bright spot there for a while…. but don’t hold me to it…

    Actually the only bright spot is the cheap dollar/exports.

  12. Oh one last thing:
    My guess is that nothing has really changed.

    It will. Shadow banking… investment banks were/are leveraged 25 to 35 to 1. That’s about to end. Under the new guidelines that will come out they will only be allowed to leverage 8-12 to 1 like a regular banks. Investment banks no longer have a future and leverage is going to come down a great deal.

  13. JC, sorry for missing the joke.

    More seriously, all this stuff about implicit guarantees from the government, people getting what the voted for, doing things because life is difficult due to fighting two useless wars in far flung places (three if they start one with Iran) etc. makes you sound like a good candidate for the communist party. Why not renationalize Ford and GM when they go broke too? Great icons, who also had implicit guarantees at least as strong as any bank did.

  14. Conrad:
    people getting what the voted for, doing things because life is difficult due to fighting two useless wars in far flung places (three if they start one with Iran) etc. makes you sound like a good candidate for the communist party.

    really? I sound as though I’m a commie? That’s pretty unique.

    The electorate is complicit in maintaining the guarantee, Conrad. You just can’t allow politicians and the executive to make verbal , underhanded promises for 70 odd years during the twins existence and expect to walk away. There’s no mistake here.

    Another of FDR’s fuck up’s comes to light 70 years later.

    The war on terror is very costly.

    And no, Ford and GM, two large healthcare companies that happen to make cars on the side and are basically broke should be allowed to fail.

  15. JC,

    1) what kind of crazy governments go to war in places that they can never win (go ask a Russian), apart from stupid authoritarian ones? If the wars are so costly, then the simple solution is to get out. Better to spend money on yourself than people that hate you (and always will), especially if you need it. You might still have a war on terror, but it will be vastly cheaper.

    2) “You just can’t allow politicians and the executive to make verbal , underhanded promises for 70 odd years during the twins existence and expect to walk away”

    Then charge the politicians if they have done something illegal. Try not to be so gullible next time. Politicians are always promising things they fail to deliver. Its a good reason to try and minimize their role.

    3) “And no, Ford and GM”

    You might believe that, but if we think of “implicit” guarantees, then surely they have better arguments than anyone else — the US spends billions keeping petrol cheap if you consider the cost of war and their bases around the globe. More generally, there are “implicit” guarantees that would need to be considered for numerous government things like education, health care, pensions etc. which this type of reasoning would lead to.

  16. Conrad, President Roosevelt is so arrogant, that I bet he wouldn’t even turn up for his court case! And, since he was otherly-abled, he would get lots of sympathy votes from any jury! We can’t win this one.

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