A Crazy Plan for Hank Paulson on Saving Fannie, Freddie, and Lehman

When Hank Paulson took his post as US Treasury Secretary, he probably thought it would be a nice relaxing break from the high-stress job of running Goldman Sachs.  After all, what does a Treasury Secretary do, other than shake hands with figureheads and make emphatic statements claiming to support his administration's "strong dollar policy?"  Mr. Paulson, however, has found himself in the difficult position of attempting to bailout most of the US financial sector while avoiding the use of taxpayer funds.  The US market narrowly avoided a complete meltdown in March when Paulson forced JP Morgan to buy Bear Stearns.  It would've been the perfect plan were it not for the $29 billion in dicey mortgages that the Fed has guaranteed for JP Morgan.  No use of taxpayer funds, yet.  Expanding the type of collateral that the Fed will take in its loans to Wall Street to include triple AAA rated MBS and ABS was also inspired genius, assuming that none of these institutions fail and leaves the Fed holding undesirable collateral in a panicky market.  Opening the discount window to investment banks was a shrewd move to shore up confidence and keep Lehman from facing Bear's fate in March.  Investment banks have yet to tap the discount window.  So far, so good.  When Fannie and Freddie's stocks began to plummet on fears that they were insolvent, Paulson crammed through a landmark housing bill that had stalled in congress in order to make the implied government guarantee explicit.  Although I am not a mind reader, I believe that Paulson was hoping that the explicit guarantee would boost confidence so much that the government would never have to take an equity stake in the faltering mortgage entities.  The market, however has called his bluff.  Fannie and Freddie's shares have been reeling, dragging down the recently rebounded financial sector on a belief that the government will have to make an equity infusion that will wipe out the common and potentially the preferred shareholders.

Since desperate times call for desperate measures, I have a crazy plan for Mr. Paulson on how to save Fannie, Freddie and Lehman while making a few bucks in the stock market.  First, call Lehman Brothers and tell them that the government plans to buy one billion shares of Fannie and Freddie tomorrow, giving Lehman one trading day to front-run the order.  Then, Mr. Paulson can give the order to Lehman to buy one billion shares the following day at the market.  Since this is around ten times the average daily volume, both of the stocks should spike significantly.  A short squeeze will follow as the small-time shorts get squeezed out.  Mr. Paulson can then call Chris Cook at the SEC and tell him to put out an emergency short-sale ban.  The SEC must outlaw ALL shorting, not just the naked variety.  The stocks will surge higher as shorts are forced to cover.  Once both share prices have quadrupled, Fannie and Freddie can raise more capital from a few strategic foreign investors.  After all, this has got to look like a great investment compared to the Chinese or Indian stock markets of late.  Although the government's share will be diluted by the new capital raising, it should be more than offset by the appreciation in the stock.  Lehman, having front-run the buy side, can also front-run the equity issuance and post a gain that may help offset the $4 billion or so in losses that it is more than likely to have this quarter.

If all of this sounds crazy, then you haven't been keeping up with current events.  It only seems slightly more crazy than the reality confronting the market.  Fannie and Freddie on the verge of a direct equity infusion from the government?  Insanity!  Lehman's stock getting annihilated again because all of those "rumors" about untenable losses turned out to be true?  Shocking!  Is everyone at Lehman "comfortable" with those marks now that the investment bank is yet again desperately searching for new ways to raise capital?  Erin Callan can thank Dick Fuld for giving her the boot, as it was a better move for her career than Mr. Fuld's.  Mr. Fuld has nowhere else to point the finger.

Only time will tell how the turmoil in the financial markets will finally be resolved.  You can bet on more surprises along the way.  The only thing that seems certain is that the financial universe will continue to shrink as players get weeded out during the downturn.  Pundits attempting to call the bottom will eventually grow weary.  Only when completely crazy ideas begin to sound reasonable will a bottom begin to form.  When I get a call from Mr. Paulson asking for the outline of my plan, I'll let you know it's safe to buy financials again.