The real capital of Fannie Mae and Freddie Mac is the government's now-explicit commitment to invest in them if necessary.

This capital is committed but not paid in. Is that good enough for the bond market?

The whole point of the government's commitment is to keep people buying Fannie and Freddie senior debt and mortgage-backed securities with confidence. But uncertainty about how a capital transaction might work does not help.

Financial and political discussions are focused on the uncertainty, but Treasury representatives have said repeatedly that they have no plans to make an investment, though everybody knows they are working nights and weekends on contingency plans. What specifically would be done? Would the common stock — and perhaps the preferred stock, which is widely held among banks — be "wiped out"?

One money manager asserted last week to Bloomberg News that the Treasury has provided "zero clarity on the issue, and until the market knows" where the Treasury "is going to be in the capitalization structure, then it gets worse and not better." It has certainly been not only "worse," but terrible for holders of Fannie and Freddie common and preferred stocks. But they do not really factor into the decision; what matters is the behavior of the bond market.

We are in a classic phase of a financial bust, when governments are forced to use public money to pay for the losses of financial actors in the name of market and economic stability. (The intellectual debates about this go back at least to 1802, when Henry Thornton published "An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.")

Large parts of the U.S. paper mortgage credit involve an uncomfortable combination of the public's desire to hold instruments seen as riskless, such as Fannie and Freddie debt and bank deposits, and the willingness to fund a risky business subject to occasional losses higher than anyone imagined possible.

When bubble has turned to bust, the government's reactions tend to move through four phases:

  • Issuing assurances, such as "The subprime problems are contained."
  • Waiting and hoping while delaying losses — a feat made harder by "fair-value" accounting.
  • Providing "liquidity" (i.e., lending money) to pressed institutions.
  • The last phase: When losses have grown so great that it is feared they have run through the available capital; when waiting, hoping, and issuing assurances have not succeeded; when uncertainty and risk premiums are very high; financial firms are provided not with more short-term debt, but with more capital.

This is where we are with Fannie and Freddie, as reflected in the Housing Act of 2008.If the bond market decides that committing government capital is not enough, and that it needs to be actually paid in, how should this investment be structured? It is high time to get specific about what the details of a Treasury (taxpayer) investment in Fannie and Freddie should be.
I propose that the Treasury invest about $10 billion of capital in of each, making it entirely clear to the senior bond and mortgage-backed investors that they can continue to finance the mortgage market in safety.

This investment should be senior to all existing capital — common stock, preferred stock, and subordinated debt. It should thus be in the form of senior subordinated debt at the top of the capital structure, the last capital to suffer any losses and the first to get cash returns.

It should have a cash yield to the Treasury of 4%, about the 10-year Treasury bond rate, so the taxpayers have no net cost of carry.

No dividends on the common stock or any preferred stock could be paid without the express approval of the secretary of the Treasury, so no dividends would be paid for some time.

An additional "pay-in-kind" interest payment should accrue to the Treasury at 11% a year, bringing the taxpayers' potential rate of return for the risk they are taking up to a fair level of 15%.

Five new directors should be appointed by the Treasury, with their fiduciary duty defined as running to the taxpayer-investors. At least two of these directors must be members of the compensation, audit, and governance committees.

The senior subordinated debt should be redeemable at par plus all accumulated pay-in-kind interest when the government-sponsored enterprise achieves a capital ratio, not including the Treasury's investment, of 5% of assets plus 1% of off-balance-sheet mortgage-backed securities.

This would be a sensible way for senior creditors to be fully protected while current equity holders pay the price for the risks they took. Both common and preferred shareholders would still preserve an interest, though junior to the pay-in-kind accruals, in the upside and profits of the post-bust Fannie and Freddie.

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