By Steven Pearlstein
Friday, August 22, 2008

Message for Hank Paulson: It's time to get out the bazooka.

That was the Treasury secretary's inelegant metaphor for the authority recently given him by Congress to pump government money into the ailing giants of housing finance, Fannie Mae and Freddie Mac. Paulson's theory of deterrence is that if you had a big enough financial backstop, it would restore the confidence of markets in Fannie and Freddie's financial viability so that it would become unnecessary to actually use it.

It's a fine theory, but for some reason it hasn't worked out that way. A nervous stock market, fed by rumors and suspicious press leaks from the White House, has driven the combined market value of the two companies to below $7 billion on the expectation that a federal takeover is inevitable and shareholders will be wiped out in the process. The falling stock price, in turn, has spooked bond investors who, while still willing to lend money, are demanding an extra three-quarters of a percentage point to compensate for additional risk.

Paulson's miscalculation was to think that markets would respond rationally to his show of overwhelming financial force. But the markets have become understandably irrational when it comes to anything to do with housing, and to the financial institutions that together have guaranteed half of all mortgages in the United States.

Despite the best effort of the companies and the Treasury in recent weeks, talk therapy hasn't worked. Fan and Fred are caught in one of those situations in which expectations have become self-fulfilling, making a government takeover inevitable. Better to do it now -- this weekend -- before the companies are damaged any further and the housing market with them.

Contrary to what you may have read, nobody knows whether Fannie and Freddie are insolvent -- not even former Federal Reserve chairmen or editorial writers for the Wall Street Journal. To know that, you'd have to know what percentage of mortgages will go into default over the next several years, whether those defaults will result in workouts or foreclosures, and how much of a loss in principal and interest payments those workouts and foreclosures will entail. And to know that, you'd have to know how much further house prices have yet to fall.

Despite all this uncertainty, accounting rules require the companies to make a best guess about such things in calculating their quarterly profits. They also require them to estimate what they could get for some of the mortgages and mortgage-backed securities on their books if they were sell them into today's depressed markets, even if they have no intention to do so. And every dollar that is written off or added to loss reserves is not only subtracted from operating profits, but also is subtracted from the pool of "regulatory capital" that the companies are required to maintain as a financial cushion to reassure creditors that they will be repaid.

This doesn't mean that the companies are short of cash. In fact, they're rolling in it -- a combined $66 billion at the close of the second quarter. In the first six months of this year, both Fannie and Freddie generated about $5 billion each from day-to-day operations -- it was only after factoring in such non-cash items as write-downs and loan loss reserves that net income turned negative. That both firms have been able to roll over old debt and float new debt means that they are not facing the kind of liquidity squeeze that brought down Bear Stearns.

From Mr. Market's perspective, however, strong cash flow is not enough when each quarter's paper losses bring Fannie and Freddie perilously closer to falling below the capital standards set by regulators and Congress. And as we've learned from the current crisis, even those standards are too low. To be viable as sound financial institutions, Fannie and Freddie need to raise tens of billions of dollars in additional equity capital. Given their deeply depressed share prices and the risk of a government takeover that could wipe out the value of any new investment, raising that kind of money will be impossible.

There are many ways to structure a government rescue -- Treasury officials and investment bankers from Morgan Stanley have been sketching out various options for weeks. My guess is that any plan would involve the Treasury pledging to invest at least $50 billion in the two companies in exchange for a new class of preferred stock. At current market valuation, that would entitle taxpayers to at least 85 percent of the ownership of each firm, a dividend equal to the Treasury's borrowing cost and a super voting majority on the board of directors. While the new directors would be free to decide whether to keep or fire top executives, the politics of the situation would probably demand the departures of chief executives Dan Mudd and Dick Syron, along with a respectable reduction in their contracted severance benefits.

Why not wait until Fannie and Freddie are on the brink of collapse, their stocks selling for pennies and their credit ratings taken down two or three notches? The simple answer is contagion. Because financial markets remain extremely vulnerable, the last thing they need is another month or two of added uncertainty as the Fan and Fred soap opera plays itself out, most likely with the same outcome. Fannie and Freddie are not just any old financial institutions -- they have $1.6 trillion in outstanding bonds that, until now, have been treated as if they were as safe as U.S. Treasury bonds and are widely held by banks, money funds and central banks around the world. Continued uncertainty about Fannie and Freddie means continued uncertainty about them.

Doing the takeover now, of course, would mean that Fannie and Freddie shareholders would not be completely wiped out. No doubt that would get the chattering class in a lather about another taxpayer bailout for Wall Street. The reality, however, is that for most Fannie and Freddie shareholders -- and for its impact on future behavior -- there is little practical difference between losing 95 percent of your investment and losing it all. As for the taxpayers, the most likely scenario is that they wind up making money on the deal once the housing market recovers.

Longtime critics of Fannie and Freddie have rushed to embrace the "nationalization" scenario as a first step toward severing their link to the federal government and selling them off in pieces to competitors or private investors. But those are decisions that can only be made by a new Congress and a new administration, and only after the housing and credit markets have recovered. Speculating on it now may be great sport, but it is way premature.

Steven Pearlstein can be reached atpearlsteins@washpost.com.