Parsing Paulson: It's a Systemic Thing

Call it the "soft launch" of the Fran-Fred takeover.

Spoon-fed with lots of accurate details from unidentified sources, Friday's reports outlined the basics of the deal, and Saturday's follow-up stories thoroughly chewed the analytical cud. So by the time Treasury Secretary Henry Paulson stood up at Sunday's press conference, he knew that the potentially controversial move had already been almost fully digested.

Even so, a quick parsing of Paulson's long statement reveals that the Treasury Secretary knows he is making some hard choices.

Paulson: Good morning. I'm joined here by Jim Lockhart, Director of the new independent regulator, the Federal Housing Finance Agency, FHFA.

Translation: Good morning. We're here to confirm the strategic leaks.

Paulson: In July, Congress granted the Treasury, the Federal Reserve and FHFA new authorities with respect to the GSEs, Fannie Mae and Freddie Mac.

Translation: In July, Congress handed us the monkey.

Paulson: Since that time, we have closely monitored financial market and business conditions and have analyzed in great detail the current financial condition of the G.S.E.'s -- including the ability of the G.S.E.'s to weather a variety of market conditions going forward.

Translation: We didn't jump to conclusions.

Paulson: As a result of this work, we have determined that it is necessary to take action.

Translation: The moves we are making are deliberate, not panicky.

Paulson: Since this difficult period for the G.S.E.'s began, I have clearly stated three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers -- both by minimizing the near term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the G.S.E. structure.

Translation: We have a clear philosophy that will guide every action we take.

Paulson: Based on what we have learned about these institutions over the last four weeks -- including what we learned about their capital requirements -- and given the condition of financial markets today, I concluded that it would not have been in the best interest of the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form.

Translation: We're not going to fund the perpetuation of a losing model.

Paulson: The four steps we are announcing today are the result of detailed and thorough collaboration between F.H.F.A., the U.S. Treasury, and the Federal Reserve.

Translation: Guess who drove?

Paulson: We examined all options available, and determined that this comprehensive and complementary set of actions best meets our three objectives of market stability, mortgage availability and taxpayer protection.

Translation: Did I already mention we have a clear philosophy that will guide all of our actions? Anybody still holding shares wasn't paying attention.

Paulson: Throughout this process we have been in close communication with the G.S.E.'s themselves. I have also consulted with Members of Congress from both parties and I appreciate their support as F.H.F.A., the Federal Reserve and the Treasury have moved to address this difficult issue.

Translation: Working in government is not like herding cats. It's like herding rats. Fortunately, nothing gets people in line like a genuine crisis.

Paulson: Before I turn to Jim to discuss the action he is taking today, let me make clear that these two institutions are unique.

Translation: Before I turn to Jim to discuss the action he has been driected to take today, let me make clear that we are not getting into the bail-out business. Really, we're not.

Paulson: They operate solely in the mortgage market and are therefore more exposed than other financial institutions to the housing correction. Their statutory capital requirements are thin and poorly defined as compared to other institutions.

Translation: They have never been run as real businesses.

Paulson: Nothing about our actions today in any way reflects a changed view of the housing correction or of the strength of other U.S. financial institutions.

Translation: Our actions reflect our previously established view. Things are neither better nor worse, and so don't characterize these actions as a reflection of either.

(Lockhart statement.)

Paulson: I support the Director's decision as necessary and appropriate and had advised him that conservatorship was the only form in which I would commit taxpayer money to the G.S.E.'s.

Translation: I support the Director's decision to follow directions, and had advised him that would not be turning over this kind of money without also taking control.

Paulson: I appreciate the productive cooperation we have received from the boards and the management of both G.S.E.'s.

Translation: Desperation tends to inspire productive cooperation.

Paulson: I attribute the need for today's action primarily to the inherent conflict and flawed business model embedded in the G.S.E. structure, and to the ongoing housing correction.

Translation: Bad models don't survive bad times.

Paulson: G.S.E. managements and their Boards are responsible for neither.

Translation: G.S.E. managements and their Boards should not be sued by shareholders.

Paulson: New C.E.O.'s supported by new non-executive Chairmen have taken over management of the enterprises...

Translation: You can't really have a New Day unless you have New Faces.

Paulson: ...and we hope and expect that the vast majority of key professionals will remain in their jobs.

Translation: But we're hoping the people who actually do the work will remain at their desks.

Paulson: I am particularly pleased that the departing C.E.O.'s, Dan Mudd and Dick Syron, have agreed to stay on for a period to help with the transition.

Translation: We're not firing them, which would be an assignation of liability. But $9 million and $14 million should buy us a wonderful transition.

Paulson: I have long said that the housing correction poses the biggest risk to our economy.

Translation: It used to bore the other children at recess. If only they'd listened to me.

Paulson: It is a drag on our economic growth, and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us. Fannie Mae and Freddie Mac are critical to turning the corner on housing.

Translation: Don't you see? You're thinking of this place all wrong...

Paulson: Therefore, the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability.

Translation: We're no longer going to pretend these public services are actually businesses.

Paulson: To promote stability in the secondary mortgage market and lower the cost of funding, the G.S.E.'s will modestly increase their M.B.S. portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.

Translation: We need to get through this crisis, and then prevent the next one. I just hope my successor's successor's successor will stick to the plan.

Paulson: Treasury has taken three additional steps to complement F.H.F.A.'s decision to place both enterprises in conservatorship. First, Treasury and F.H.F.A. have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth

Translation: We've taken control.

Paulson: These agreements support market stability by providing additional security and clarity to G.S.E. debt holders -- senior and subordinated -- and support mortgage availability by providing additional confidence to investors in G.S.E. mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations.

Translation: You can stop breathing into that paper bag.

Paulson: It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers.

Translation: It's not a bail-out.

Paulson: Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

Translation: Like I said, we're no longer pretending this is a real business.

Paulson: These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the G.S.E. Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS.

Translation: It's almost if the "ambiguities" were intentional.

Paulson: Our nation has tolerated these ambiguities for too long, and as a result G.S.E. debt and M.B.S. are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free.

Translation: "Our nation" sounds so noble. "Our Congress" just sounds too accusatory.

U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of G.S.E. debt and M.B.S.

Translation: Things like this never get fixed until they completely break down.

Paulson: Market discipline is best served when shareholders bear both the risk and the reward of their investment. While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.

Translation: Investor beware.

Paulson: Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses.

Translation: I'm almost sure I mentioned that we have a clear philosophy driving all of our actions.

Paulson: The federal banking agencies are assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac.

Translation: We've taken a big whack at the root cause, but the symptoms will continue for some time.

Paulson: The agencies believe that, while many institutions hold common or preferred shares of these two G.S.E.'s, only a limited number of smaller institutions have holdings that are significant compared to their capital.

Translation: The collateral damage will only be lethal in a few instances.

Paulson: The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized."

Translation: Dial 1 for English, 2 for Espanol.

Paulson: The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.

Translation: We have a clear philosophy, but we also know we've got to minimize the negative implications of that philosophy.

Paulson: Preferred stock investors should recognize that the G.S.E.'s are unlike any other financial institutions and consequently G.S.E. preferred stocks are not a good proxy for financial institution preferred stock more broadly.

Translation: Do not set your valuations based on what we've done. It's not fair to the shareholders, but it's still the right thing to do.

Paulson: By stabilizing the G.S.E.'s so they can better perform their mission, today's action should accelerate stabilization in the housing market, ultimately benefiting financial institutions.

Translation: It's call the "trickle-around" principle.

Paulson: The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.

Translation: Bargains are available for well-capitalized institutions willing to assume some, uh... risk.

Paulson: The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

Translation: We're keeping control of the money.

Paulson: Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the G.S.E.'s to be in a stronger position to fund their regular business activities in the capital markets.

Translation: Instead of serving two masters poorly, we're hoping they'll serve one master relatively competently.

Paulson: This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.

Translation: It's a backstop, not a pit stop. And it ends forever December 2009.

Paulson: Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase G.S.E. MBS. During this ongoing housing correction, the G.S.E. portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the G.S.E.'s have grappled with their difficulties, we've seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the G.S.E.'s are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new G.S.E. MBS. Additional purchases will be made as deemed appropriate.

Translation: No, Treasury is not getting into the mortgage business. Not really, anyway.

Paulson: Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and G.S.E. MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains.

Translation: We used to do smart stuff like this at Goldman all the time. It was so much more fun that what I do now.

Paulson: This program will also expire with the Treasury's temporary authorities in December 2009.

Translation: This program will expire 10 months after I'm gone.

Paulson: Together, this four part program is the best means of protecting our markets and the taxpayers from the systemic risk posed by the current financial condition of the G.S.E.'s. Because the G.S.E.'s are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking.

Translation: I'm telling you what I told you.

Paulson: The Preferred Stock Purchase Agreements minimize current cash outlays, and give taxpayers a large stake in the future value of these entities. In the end, the ultimate cost to the taxpayer will depend on the business results of the G.S.E.'s going forward. To that end, the steps we have taken to support the G.S.E. debt and to support the mortgage market will together improve the housing market, the US economy and the G.S.E.'s' business outlook.

Translation: We've done our best, but there's still much risk.

Paulson: Through the four actions we have taken today, F.H.F.A. and Treasury have acted on the responsibilities we have to protect the stability of the financial markets, including the mortgage market, and to protect the taxpayer to the maximum extent possible.

Translation:

Paulson: And let me make clear what today's actions mean for Americans and their families.

Translation: And let me resort to political rhetoric.

Paulson: Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today.

Translation: I'm still trying to figure out how we can also link this nationalization to gas prices and capturing bin Ladin.

Paulson: While we expect these four steps to provide greater stability and certainty to market participants and provide long-term clarity to investors in G.S.E. debt and MBS securities, our collective work is not complete.

Translation: I'm about to pass the monkey right back.

Paulson: At the end of next year, the Treasury temporary authorities will expire, the G.S.E. portfolios will begin to gradually run off, and the G.S.E.'s will begin to pay the government a fee to compensate taxpayers for the on-going support provided by the Preferred Stock Purchase Agreements. Together, these factors should give momentum and urgency to the reform cause. Policymakers must view this next period as a "time out" where we have stabilized the G.S.E.'s while we decide their future role and structure.

Translation: You have been warned, and my hands will be clean.

Paulson: Because the G.S.E.'s are Congressionally-chartered, only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission. The new Congress and the next Administration must decide what role government in general, and these entities in particular, should play in the housing market. There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form. Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. And policymakers must address the issue of systemic risk.

Translation: Consider the monkey returned... with a smart new suit and decent haircut.

Paulson: I recognize that there are strong differences of opinion over the role of government in supporting housing, but under any course policymakers choose, there are ways to structure these entities in order to address market stability in the transition and limit systemic risk and conflict of purposes for the long-term.

Translation: Gee whiz, people, somebody had to make some choices based on simple business fundamentals.

Paulson: We will make a grave error if we don't use this time out to permanently address the structural issues presented by the G.S.E.'s.

Translation: I'm not interested having "grave error" added to my otherwise sparkling history.

Paulson: In the weeks to come, I will describe my views on long term reform. I look forward to engaging in that timely and necessary debate.

Translation: I've got to lock down as much as I can before I go.