Former Treasury Secretary Paulson knows these matters cold. He dreams Covenants. And while he was running Treasury you can bet that he had top-notch lawyers around him 24/7.
Paulson left a stinky Covenant in the Fannie Mae deal. It is stinky because it is has or will blow up very soon. Fannie Mae will soon be running into a limit on its total debt as a result of the Restrictive Covenant.
In my view Hank Paulson is one of the smartest guys on Wall Street. He understood when he put a plan forward to ‘fix’ Fannie Mae that the plan was flawed. That it would, by it’s own constraints, create problems in the first 100 days after the Inauguration. Sort of like a time bomb.
I cannot figure that out. But it was deliberate. Maybe Paulson set this up so the issue of debt limitations on Fannie Mae would come back on the table with a new Administration. Maybe it was one of those nasty things that drafters of Covenants do. Either way it is an in your face for Paulson’s old pal Timmy Geithner.
I will try to explain.
A Covenant is a promise that a company makes when it borrows money. It is part of the broader terms and conditions. Examples would be “We Promise we will do X, or We promise we won’t do Y”. Normally these are expressed with numbers or ratios. “We will not let our debt exceed Z”, “We will not let our equity to fall below A” are examples.
Paulson’s crew drafted a Covenant in the Fannie Mae deal that limited the amount of indebtedness that Fannie could have. Follows is a link to the Fannie Mae page where this came out last night and a cut and past of their discussion of the problem. (Nice that it comes out on Friday night when folks are not looking at this stuff)
http://www.fanniemae.com/ir/monthly/index.jhtml;jsessionid=V02MGNVHMHMLFJ2FECISFGI?s=Monthly+Summary.
On page one of the November report, the sixth footnote on the right hand side reads:
A covenant in the senior preferred stock purchase agreement with the U.S. Treasury Department prohibits Fannie Mae from exceeding 110 percent of its aggregate indebtedness as of June 30,2008, which the company estimated to be $892 Billion. As of November 2008, Fannie Mae estimated that its aggregate indebtedness under the senior preferred stock purchase agreement totaled $885.6 billion.
If you look at the October report you will see that this is the first time that Fannie has made this disclosure in its monthly public filings. Very convenient.
There was a restriction on the Portfolio size of Fannie as well. The Portfolio limits were swept away by FHA earlier last week. Portfolio limits are easy to adjust. Covenants on debt limits are a much more thorny issue. There were two covenant limitations put on Fannie. One to limit growth, the other to limit debt. Two Ways. The lawyers call this belt and suspenders. Two Ways to hold up your pants. Heaven forbid that their pants fall down.
Paulson laid a stinky and the lawyers are probably laughing about it at Harry’s Bar. However, the new administration is not laughing at this. They are going to have to ‘fix’ this problem. It is going to take time, money and legislative effort to do that.
I have stuff that breaks all the time. My problem is that I try to fix things with duct tape and glue. It always breaks again in a few months. The answer is always the same. If something is broken, fix so that it will stay fixed. Paulson put duct tape on our financial problems. We are leaking again already, and it is only ten days since he left Washington. It sure makes me wonder how many other things are going to start leaking in the near future. ‘They’ used a ton of duct tape in the last three months they were in charge.
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