Desperate times call for desperate measures

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I have what Wall Street calls a Strong Buy recommendation: buy the senior debt of Fannie Mae and Freddie Mac. You can get a good spread over US Treasuries. If you want more leverage, and you have a line with a credit default swap dealer, then sell five-year protection on the names. If the spreads rise, then buy some more.

I know what you’re thinking. As they say in the City: “Where there’s a tip there’s a tap.” Very well, I’ll admit it. I expect to be an equity owner of Fannie and Freddie, so, yes, I am using the FT to push debt securities in what will be my own companies, though I would be sharing ownership with the other 132m income tax payers.

You may wish to hedge this position, which, if you take all the paper around, will come to $5,000bn (£2,527bn, €3,170bn). So put on an offsetting short position of duration matched US Treasuries. Fortunately, there’s plenty of liquidity in both sets of securities.

Now, there are distinguished US officials who will sharply disagree with my outlook. That raises the question, though: distinguished by what?

In the case of Henry Paulson, secretary of the Treasury, it would seem he is distinguished by a profound, possibly intentional, ignorance of what he is talking about, and a central nervous system that would not seem to be capable of abstracting possible future outcomes beyond one news cycle.

Last week, for example, Secretary Paulson gave a speech in which he described covered bonds as a “promising vehicle” for mortgage finance. “As Treasury seeks to encourage new sources of mortgage funding in the United States, improve underwriting standards, and strengthen financial institutions’ balance sheets, covered bonds have the potential to serve these purposes, and reduce the costs for first-time home buyers, and for existing homeowners to refinance.”

That was not written by someone who thought it through. Covered bonds are bonds issued by a financial institution that are collateralised by residential mortgages, and which remain on the balance sheet of the issuer. So unlike, for example, the securitised subprime paper after which this crisis is named, the buyer of the securities has, effectively, recourse not only to the collateral pool, but to the general earning power and net worth of the issuing institution.

For that to work as Mr Paulson would intend, though, the institutions would, it seems at first glance, need to have some earning power, or at least some net worth to meet capital adequacy rules. In the case, for example, of IndyMac, a large US mortgage lender that has hit trouble, any covered bonds it issues might not sell at a large premium to securitised mortgage-backed paper it would sell without recourse. Far from serving to “strengthen financial institutions’ balance sheets”, the introduction of covered bonds to the US market would require a lot more capital added to those balance sheets to cover the added exposure, and higher, government-tweaked, cash flows over time.

Instead of using improved disclosure, more transparent structures, honest ratings services, and ethical, post-prosecution-wave, investment dealers to ensure that housing securities are sound, Mr Paulson would impose yet another bank capital call on the markets, and, probably, the taxpayers.

Desperate times call for desperate measures. In the case of this administration, such measures might include researching all the knock-on effects of proposals. I know they don’t have much longer, but it would be nice not to have the next lot left with even more smoking holes in the ground.

The US government, and its associated institutions, should also look at how it can take a direct role in what would be, effectively, the underwriting of standard-form core capital issues for the country’s banks.

When I suggested this to some responsible people early this year, they dismissed the idea of sponsoring “one-size-fits all” capital raises. They were confident the interplay between the market and the banks would lead to appropriate, institution- specific, structures.

We seem to have run out of time on that approach. The market is not enthusiastically waiting for new bank preferred stock issues. After a point, the yield on preferred issues gets to be prohibitive, at least without some third party sponsorship. The largest pool of prospective capital available for the US banking system is in the money market accounts of the US public. They will not buy enough new Tier One capital issues unless, possibly, the issues are standardised, understandable, senior, and endorsed by the Federal Reserve or some other respected institution.

The other prospective sources of new capital, the private equity partnerships and hedge funds, need some changes in Federal banking rules, and perhaps laws, that will loosen the requirements imposed under the Bank Holding Company Act, along with those of the Change in Bank Control Act.

Christopher Whalen, of Institutional Risk Analytics, which sells bank risk management products, has been looking into this. As he wrote recently: “ . . . with the FDIC [Federal Deposit Insurance Corporation] preparing itself for a large increase in the number of bank insolvencies, the Fed staff must be gearing up to process and approve a large number of change of control applications”.

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