Why Treasury Shielded Frannie's Sub Debt

Yet another peculiarity of the credit crunch: the WSJ editorial page seems to be in full agreement with Nouriel Roubini. The subject: Frannie's sub debt, which was shielded from any haircut by Hank Paulson's bailout.

In structuring his rescue, Treasury Secretary Henry Paulson gave a haircut to holders of both common and preferred stock. In the process, he socked it to many small banks that had much of their capital in Fan or Fred shares. He was right to do so, and he should have wiped them out given how much those holders had profited over the years from a government guarantee. But, strangely, Mr. Paulson also decided to give Fan and Fred's subordinated debt holders an entirely free pass. Why?

I asked that question myself on Tuesday, and got two extremely good answers in response. Here's dsquared:

Subordinated debt is debt, it's not equity and it's not preferred equity. You can't put an insolvent company into conservatorship and you can't keep a company solvent while defaulting on its debt. A conservatorship doesn't allow you to arbitrarily draw a line in the capital structure.

And here's John Hempton:

An equity holder who has their dividends suspended cannot make a bankruptcy filing. A preferred holder cannot make a bankruptcy filing.
A subordinated holder can make a bankruptcy filing.
That power is a good reason why you would honour their capital.

Meanwhile, the WSJ's editorialists seem to have asked Treasury directly:

Treasury's explanation is that it had to do this to reassure the world's holders of Fan and Fred senior debt. The argument seems to be that if subordinated debt holders took a loss, then senior debt holders might panic and run. And reassuring the Chinese and other holders of Fannie senior debt is the main point of this bailout.

All of these answers seem vaguely reasonable to me. I don't know if there is One Big Reason for the sub-debt bailout, but the editorial does point to one other small reason: there's "only" $15 billion in sub debt outstanding, less than 1% of Frannie senior obligations. If you imposed say a 20% haircut, that would get you $3 billion: hardly chump change, but not enough to make much of a difference to the Fannie and Freddie balance sheets.

My feeling is that after taking all the above considerations into account, Paulson came to the conclusion that attacking sub-debt holders was simply more trouble than it was worth. There's a German concept called Anstaltslast, which holds that if an entity is owned by the government, it will meet all its obligations. The idea that the GSEs would be taken over by the Treasury and then immediately default on their subordinated debt -- even though there was no indication of any imminent default when they were public companies -- is definitely a bit weird.

So although for moral hazard reasons it might have been nice to impose a haircut, I can see how sheltering the sub debt might have been a much more practical course of action -- especially since all the decisions needed to be made in one weekend and the conservatorship was complicated enough as it was.