With rumors of a rescue of some sort coming over the weekend for the GSE’s and questions yet again as to whether stock and debt holders will get kicked down elevator shafts, here are some excerpts from The IRA’s GSE Roundtable dated 7/21/08.

Bill Poole: “The US Treasury secretary is now the ad hoc receiver for Fannie Mae and Freddie Mac. Ordinarily, a receiver’s job is to protect a company from its creditors so it can realise maximum value for the creditors as a whole, who are then paid according to the seniority of each creditor’s claim. For Fannie and Freddie, the receiver’s job is to protect the financial markets, the housing market and the US taxpayer from the firms.”

As loss rates on all grades of US residential collateral rise, a formal government takeover of FRE and FNM seems inevitable. So buy the bonds and shoot the equity in the head.

… at this point the GSEs are risking the credit standing of the US government. That should be our primary concern above all. The GSEs have been using preferred debt to raise capital so that these instruments represent about 50% of GSE capitalization. The ratings agencies, who created the concept of an implicit guarantee by the way, previously suggested that going beyond 25% of total capital in preferreds would be grounds for a downgrade, but nothing has happened. If the GSEs are downgraded, then the US may find itself in danger of a downgrade as well. I can see the US standing behind the MBS, but why should the Treasury have to back up one hundred cents on the dollar of the corporate debt of the GSEs, debt which is explicitly not guaranteed and is primarily owned by foreign central banks.

The IRA: So the GSE hedge funds are financed by foreign central banks? That is funny. And you are suggesting a haircut of the holders of GSE general obligations but not the MBS?

Rosner: Some $900 billion of corporate debt is held by foreign central banks. Until recently, the foreign central banks have historically not bought the MBS but have been buyers of the corporate debt.

O’Driscoll: I’d like to see them downsized to the point where privatization is really possible. The GSEs can’t be truly privatized the size they are now.

Wallison: The point that needs to be made is that the idea of a default by the GSEs right now is completely out of the question, whatever the business model is today.

Rosner: But don’t you really only need to privatize the MBS portfolio? There really is no reason for the $1.5 trillion portfolio business to exist.

O’Driscoll: Exactly. They need to sell that portfolio over time.

The IRA: Whether we privatize or nationalize, the objective should be a final solution so that we need not spend any more time thinking about these entities. Wouldn’t you agree that getting the GSEs off the front page and into the back office is the real goal?

Rosner: Correct. You can liquidate the portfolios and run off the MBS business over time. But isn’t it audacious of Paulson and the Treasury to ask Congress for new investment powers without demanding a change in management? These are two companies that still have massive internal controls weaknesses and don’t fully have the systems to operate their business. In testimony yesterday both Paulson and Bernanke said that in performing its consultative role regarding the GSEs, the Fed and Treasury would not take action without consulting with the enterprises!

Under no circumstances can the GSEs default on their senior debt. If they were to do that, the financial intermediaries and central banks around the world that hold this paper would suffer enormous capital losses. Banks that hold this paper would see their capital decline in value along with the value of the GSE debt. Then we really would begin to see the failure of banks or at least the inability of banks to make new loans. My hope is that we can stabilize the GSEs and see the housing market also stabilize. But if Josh is right about the real estate market declining another 20 points, the GSEs will have to go into receivership. Then the question will be where is the US government going to get the money to ensure that the GSE debt is serviced.

What if we said to the central banks that we are going to give them a 10% haircut on the senior debt, not the MBS. Offer the central banks 90 cents on the dollar of long-date senior debt and 10 cents worth of new preferred. You free up $150 billion in new capital for the enterprises.

The IRA: But Josh, what is the point of raising private equity capital for an entity that must have sovereign backing in order to function? The cost of the private equity or preferred is going to be a multiple of the cost of debt with implicit Treasury backing. Isn’t the most efficient way to deal with this crisis to nationalize the GSEs and take that concern off the table for the moment so that we can focus on managing the capital needs of the banking industry?

Rosner: That’s why I’m not raising any money for the GSEs. I think we restructure the enterprises via a haircut , not on the MBS, but on the senior corporate debt. This is $150 billion in new and real equity capital.

O’Driscoll: If we get the GSEs smaller or more stable as a result of raising equity capital, that’s fine. More equity makes it easier to privatize in a real sense. And while all of this is going on, you have the investment banks going the way of the dinosaur and Treasury proposing a new vehicle for broker insolvencies.

Rosner: Yes and Treasury is worried about brokers while we are getting ready to see a couple of thousand small and medium size banks sold or closed in the next year or more.

O’Driscoll: If Josh’s prediction about the real estate market declining further is correct, then I don’t know what we’ll do about the banks.

Rosner: For one thing, the Fed needs to act immediately to revise the rules applied to control thresholds for investments in bank holding companies from 9.9% to more like 30%. This will enable private investors to come in and recapitalize the banks.

Wallison: Josh is completely right about what will be going on at FNM and FRE while they are being supported by the capital markets and by their regulators, who will be saying that the GSEs are not insolvent. It is correct that the GSEs will be taking on new risks. But the alternative is worse.

Rosner: But that is where I disagree with you, Peter. If you are talking about defaulting, then we are in agreement. But as we discussed earlier regarding the banks’ capital needs, there are different types of bankruptcy. You could present a restructuring package to the holders of the senior debt, again, not the MBS, and present a pre-pack, which is a haircut as opposed to a default.

Wallison: I just don’t think that it is realistic to talk about a haircut.

The IRA: The constituency we are talking about here is not very flexible…

Wallison: All of the holders of GSE debt would see their capital decreased across the board and it would literally kill the dollar if central banks around the world have to take a haircut. Confidence in the US government’s credit would collapse.

The IRA: I don’t think that global commercial and central banks would appreciate the nuance of your proposal, Josh.

O’Driscoll: Foreign investors would then see the Treasury’s own obligations as being untrustworthy. They would dump Treasuries and the dollar would crater.

The IRA: Look, we’ve lost two primary dealers in the past six months. We came very close to cratering the Treasury market with the Bear failure. It seems as though we are experiencing waves of erosion in confidence that are working their way up the food chain to the highest quality obligations such a Treasury debt.

Wallison: I don’t know about Treasuries, but there certainly seems to be a crisis of confidence in the various classes of asset-backed securities.

Rosner: I think a lot of the fear results from a lack of confidence that anyone is at the helm in Washington.

O’Driscoll: That’s what I was alluding to earlier.

Wallison: Yes, I am very disappointed in Paulson.

The IRA: It is astounding, isn’t it? We thought that Paulson was a master of the universe. Looking at the carnage in the housing and banking sectors, and the stories we’re hearing from the public sector. Is there a potential for this financial crisis to become the issue in the November election? We have this nightmare image of the FDIC closing several banks at once just days before voters go to the polls. Who do voters pick when the economy is in a meltdown?

Wallison: I think Paulson was trying to communicate to the global capital markets that the US would stand behind the GSEs. Buying equity in the enterprises does not make a lot of sense. But the really wacky idea is the notion of the GSEs borrowing from the Fed’s discount window when they can borrow at Treasury rates in the markets.

The IRA: As much as I’d like to see Josh’s pre-pack plan given a chance to work, it is really hard to see global central banks agreeing to such a scheme.

Rosner: Then we are probably going to see the result nobody wants, namely the junk status of the GSEs eventually transferred to the US government itself and a potential credit ratings downgrade of the US.

O’Driscoll: A question I have for Peter is this: If the enterprises are taken over, don’t they lose status as being issuers of bank eligible paper? Does not a receivership basically throw the entire mess into the arms of the Treasury?

Wallison: Yes it does. That is why we need to be very careful to avoid a default by the GSEs. I think this is part of the reason that Treasury bought onto the idea of giving the Fed a role in this process.

Comment: I can’t see the U S Gov defaulting on the senior debt but will the taxpayer have to pony up again or will the “hair-cut” referred to above prevail? And if so, will the dollar fall and commodities regain their preferred status in the market? Will holders of the preferred as well as the common see their market caps shrink or will the ebullience of the market ignore the obvious as it has with the brokers and banks? Latest stories have the treasury making a capital injection at shareholder expense …. how will the stock market react to that?