Paulson Playing Chicken With Markets: Guess Who Will Win? (GSE Edition)

Guest post today, by Yves Smith of naked capitalism:

James Carville, Clinton strategist, said,

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody.

If a politico like Carville recognized the fixed income market as an irresistible force, you’d think a Wall Street pro like Henry Paulson would give it the respect it deserves. But peculiarly, he has been acting as if he can bluster his way through a mushrooming crisis of confidence in Fannie and Freddie.

A Barron’s report over the weekend saying that the Treasury would buy GSE preference shares (and wipe out equity holders) if the companies failed to raise new equity sent the shares into a downdraft, with Freddie’s falling 25% and Fannie’s, 22%, triggering a broader market fall in the US that continued overnight in Tokyo. More troubling, GSE debt also fell, as Accrued Interest reported:

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity. Even senior paper is 7-8bps wider on the day. MBS look to be only about 4bps wider.

I’ve heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he’s been up to his eyeballs in 100 bond lots today. Haven’t heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.

So what reaction did this mini-meltdown elicit from the Administration? The Wall Street Journal tells us:

In early July, a previous plunge in the companies’ shares prompted the U.S. Treasury to announce a package of measures aimed at shoring up investor confidence. Among other things, the Treasury said it would lend money to the companies or make equity investments in them if needed.

"As the secretary has said many times, we have no plans on using the authority," Treasury spokeswoman Jennifer Zuccarelli said Monday, referring to Treasury Secretary Henry Paulson.

This is about as lame as it gets. I’m sure a PR pro could do better, but the right response is reassurance from Paulson himself: the markets are on the mend, yes, there may be bumps but things are getting better, we are on the case, will act if necessary but don’t see the need, Freddie and Fannie have plans in progress to improve their balance sheets.  That probably wouldn’t undo what Barron’s hath wrought, but it would halt the slide and produce at least a partial reversal. Investors want to hear that the powers that be are engaged and willing to pull the trigger.

What is even worse from the Adminsitration’s standpoint is that savvy observers see the bailout plan as a sham. As the Financial Times reports:

The Treasury dismissed the [Barron’s] report as “speculation”. It told the Financial Times it still had no intention of using its newly authorised power to invest in either the debt or equity of Fannie and Freddie. The question is whether it may be forced to do so.

The logic of the plan unveiled on July 13 was that the market would be reassured by the Treasury obtaining authority to invest in Fannie and Freddie, reducing the likelihood that the government would actually have to bail them out….

“Hank Paulson’s gamble is that if the Treasury commits to investing in Fannie and Freddie [if required] it will never have to put money in,” said Alex Pollock, a fellow at the American Enterprise Institute.

In other words, this was all meant to be a bluff. But the markets have called the bluff in very short order. And given the lousy and certain-not-to-get-better-anytime-soon condition of Freddie and Fannie, this outcome was entirely predictable.

What is ever weirder about the Administration’s inept denials is that they seem to be quietly moving forward in examining rescue options. A Wall Street Journal editorial, "When Henry Met Fannie," tells us:

Meantime, Treasury claims it has no plans to inject taxpayer money directly into the companies. Even so, Mr. Paulson has quietly hired Morgan Stanley, the investment bank, to look into "appropriate capital structures" if he does decide to sign the blank check that Congress has given him.

Robert Scully, the Morgan banker who will lead the effort, is by all accounts a straight shooter. And he will need to be, given the enormous political pressure he will soon face from Fannie Mae’s defenders, both at Morgan and in Washington. Morgan Stanley says it is forgoing any other investment banking business with Fan and Fred while it works for Treasury. But until recently it was among the banks advising Freddie on that elusive $5.5 billion capital infusion.

Morgan Stanley is also home to Kenneth Posner, one of the biggest Fan and Fred cheerleaders on Wall Street. Only last March, the analyst crowed about the "complete defeat" of the "anti-GSE ideologues" — that is, the people who had been right all long about the reckless risks the companies were taking. Mr. Posner also predicted that Fannie and Freddie would return to breakeven by the third quarter. Mr. Scully shouldn’t be caught in the same intellectual area code as Mr. Posner.

Disclosure: I knew Scully early on in his career. He is indeed as upstanding as they come in investment banking (yes, that is an oxymoron), very well regarded.

So why is Paulson unhelpfully (as far as market confidence is concerned) denying that he will salvage the GSEs, yet moving forward to develop plans to do precisely that? Oh, I forgot. The SIV rescue plan. Hope Now Alliance. Getting China to open its financial markets. Having JP Morgan buy Bear for $2 a share. Execution has not been the Adminstration’s or Paulson’s strong suit. Why should now be any different?

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What's been said:

Discussions found on the web:
  1. jon commented on Aug 20

    In addition to your accurate and lucid analysis, I would add one other reason for Treasury’s behavior; there is a Presidential election this year, which will be seen by many as a referendum on the Bush Administration’s stewardship of the economy. Bailing out Fan or Fred will not be easy to explain away by at least one candidate who is already tieing himself in knots trying to pretend he’s never met those guys who currently occupy the White House while he simultaneously tried to woo their mutual supporters. Political considerations influencing economic decision-making at the highest levels of government? Heaven forefend!

  2. Juhuti commented on Aug 20

    It will happen on a weekend. Probably after the Olympics when China decides to cut back on its holdings of US Treasuries. That will also be the weekend when Cox implements the new short sale restrictions on ALL stocks.

  3. larster commented on Aug 20

    Perhaps Paulson is not the actual Treasury secretary. Perhaps he appears so inept because he has to clear everything with some twenty something operative in Bush’s or Cheney’s office. I can’t think of any cabinet officer in this administration that can go to the bathroom without raising his or her hand. whatever happened to Guittieriz from Kellogg, the commerce secretary. I think the ineptness of this administration lies in their not utilizing the cabinet officers and their departments.

  4. ed commented on Aug 20

    The out of favor government is trying their level best to avoid the morass of
    moral imperative made more egregious by bailing out an institution that has so richly rewarded its officers, tainted by hundreds of millions in payouts and
    accounting scandal- which now the taxpayer appears likely to pay for. This is
    political black plague. One could therefore argue that the government is approaching the issue from a
    biased perspective beyond that which is obvious (ok well this is obvious too),
    and has an inherent interest in not bailing them out and consequently talking
    the GSE’s up as much as they can. Remember last summer’s assertions, “it’s

    The markets appear to have partially bought these, ‘no need for bailout’
    assurances taking them at face value…but face value also is measured by the
    GSE’s being “adequately capitalized”…until this week….

  5. just some guy commented on Aug 20

    Every time I hear the “we got the authority just to reduce the odds that we’ll have to use it…” argument, I think back to Fall of 2002, where the argument was that the president needed the authority to invade Iraq, because that would reduce the odds that he would need to use that authority. I wasn’t impressed with how that worked out in 2002/2003, I suspect I won’t be impressed now.

  6. Raul Duke commented on Aug 20

    Paulson poor at execution? I thought everyone at/from Goldman was perfect.

  7. VennData commented on Aug 20

    They don’t want another (recall TSE) nationalization or two on their watch.

    They want it on the record that their off-the record comments give them future deniability that they wouldn’t, shouldn’t, didn’t nationalize. This is about GOP legacy talking points.

    When Obama wipes out shareholders they’ll shout “See socialist!” and the GOP genuflectors will nod in unison.

  8. Greg0658 commented on Aug 20

    jon – “Bailing out Fan or Fred will not be easy to explain away”

    I thought Fred and Fan had almost half the mortgages. There is skin in this game. Buyout means what? Interest rate increase to pay for the new acquisition?

    IMO you are missing the forest for the trees.

  9. Greg0658 commented on Aug 20

    find another play outta the book

    before we say in a Soup Nazi voice “no Christmas for You”

  10. Scott in Chicago commented on Aug 20

    I spent just under a decade at Goldman. My opinion on Paulson, aside the fact that he’s an arrogant prick, is that he’s an arrogant prick. Well, yeah, it needed to be said twice. He’s not stupid, but he’s also not Bob Rubin clever. Paulson always seemed to think business was football; that if your team controlled and moved the other team’s line you’d win. He BELIEVES he can, through force of will, bend things his way. This is, of course, delusional thinking.

    When an idiot like Senator Jim Bunning can make you look bad, as Bunning did with Paulson, you know the street smarts meter stays near zero. Paulson is the perfect Bush-type guy: straight ahead and fuck reality. He reminds me of the captain on Generation Kill referred to by his minions as Encino Man. Paulson is a personification of the Peter Principle. Unfortunately, we are all gonna suffer.

  11. Dirk van Dijk commented on Aug 20

    One would have thought that since when he was Gov. Bush was more than happy to throw the switch or inject the poison, that he would be better at execution.

  12. winslow commented on Aug 20

    This administration is the ultimate “Peter Principle”. There has been incompetencies from day one. If it weren’t so serious, this is the greatest gag in history.

  13. Pat G. commented on Aug 20

    “Execution has not been the Adminstration’s … strong suit.”

    That’s what Russia is thinking right now.

  14. tom a taxpayer commented on Aug 20

    Scott in Chicago,
    Paulson is packing his bags to get out of Dodge. Paulson will want to get out before the major investigations, indictments, and prosecutions get underway after a new President is sworn in next January. Paulson is making sure his passport is in good order, his foreign bank accounts are full, and his address book of overseas buddies is up-to-date. His hardest task now is to research which countries do not have extradition treaties with the U.S.

  15. Jessica commented on Aug 21

    “I’ve heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he’s been up to his eyeballs in 100 bond lots today. Haven’t heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.”

    This cannot be possible, can it? If someone is selling, then someone is buying exactly as much. If there is zero buying, there can be only zero selling and “panicky desperate but futile desire to sell”.

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