Paulson's Revealing Comments

WSJ: The stability of Fannie Mae and Freddie Mac is key to erasing underlying uncertainty in U.S. financial markets and making way for an economic recovery, Treasury Secretary Henry Paulson said Tuesday, while voicing confidence that Congress will approve a rescue plan for the mortgage giants this week. "Because of their size and scope, Fannie and Freddie's stability is critical to financial market stability," he said in a speech at the New York Public Library. "Their continued activity is central to the speed with which we emerge from this housing correction and remove the underlying uncertainty in our financial markets and financial institutions." Mr. Paulson's speech comes a little more than a week after the Treasury Department unveiled a plan that would increase the government's US$2.25 billion credit lines to Fannie and Freddie and allow the government to buy an equity stake in either company. Lawmakers on Capitol Hill are expected to wrap the proposals into broader housing legislation.

"We need to act in the short term because the [government-sponsored enterprises] are vital institutions in our capital markets today and are vital to emerging from the housing correction." Mr. Paulson said his "highest priority" is to stabilize the financial markets and financial institutions, which have been suffering this year in wake of the subprime mortgage crisis and related credit crunch. "Today our No. 1 priority is market stability as we work through the current market stress," he said.

As part of his efforts to stabilize the financial system, he said he had no choice but to ask Congress for new authorities to prop up battered mortgage finance giants Fannie Mae and Freddie Mac. "I would rather not be in the position of asking for extraordinary authorities to support the GSEs," he said. "But I am playing the hand that I have been dealt."

Meanwhile, Mr. Paulson said continued stresses in the financial markets should be expected until the housing market fully stabilizes. Still, he said the failure of IndyMac Bank shouldn't lead people to believe the U.S. banking system is at risk. "The American people have every reason to remain confident that the U.S. banking system is sound," he said, adding that 99% of the country's banks are well-capitalized. He added that periods of economic difficulty aren't new. "We will work through this period, as we always do," he said.

At the same time, he urged banks to continue to raise capital, noting that U.S. financial institutions have already raised more than US$150 billion. Mr. Paulson said it will take "additional time" to work through the current market turmoil as the markets and banks reassess risk and re-price securities across a number of asset classes and sectors. Meanwhile, "additional bumps in the road" can be expected," he added. Mr. Paulson highlighted the need for improved market infrastructure and increased transparency, especially in the over-the-counter derivatives market and the tri-party securities repurchase system. He also said "we need to get to the point where large, complex financial institutions are not perceived to be too big or too interconnected to fail."

The Treasury secretary also called for new powers to manage the impact of the failures of large non-depository financial institutions, such as large hedge funds. "Over the last few weeks, the need to move more quickly toward an optimal regulatory structure that establishes a prudential financial regulatory system, focused on promoting long-term market stability, has become all the more apparent," he said.

Bill Gross, who manages the world's biggest bond fund (Pimco, a unit of Munich-based Allianz SE, has US$830 billion of assets under management.), said it's not possible for government sponsored mortgage-finance companies Fannie Mae and Freddie Mac to raise capital without the Treasury Department's support. `Let's be blunt: to the extent the Treasury suggests they'll never have to use their authority, that's a sham,'' said Gross of Pacific Investment Management Co. ``It's fallacious to suggest that the agencies could issue capital, preferred stock, without the co-participation of the Treasury. I don't think that's possible.''``To suggest that the Fed or a central bank should raise interest rates in the face of a significant asset deflation, a significant housing deflation, is certainly the wrong approach, to put it mildly,'' Gross said. An increase in the target rate for overnight lending between banks amid rising unemployment ``would be tantamount to raising interest rates in the mid- 1930s,'' he said. The U.S. dollar will continue to fall against currencies of emerging-market countries, Gross said. The dollar will also weaken as the U.S. federal budget deficit, which widened to US$163 billion last year, swells to as much as US$1 trillion and leads to larger sales of U.S. government debt, he said.

``Three years hence, we will see a trillion-dollar deficit to support the U.S. economy,'' Gross said. ``That's a lot of paper, and that's a lot of compression downward of the value of the U.S. dollar against most other currencies.'' U.S. Treasuries including Treasury Inflation Protected Securities, or TIPS, remain ``overvalued'' relative to assts like mortgages and corporate bonds, Gross said.

Comments: If you read Paulson's words carefully, you will come to the conclusion that the Treasury will be bailing out Fannie & Freddie. Not only that, his sentiments point directly to more bailouts, and that the end is not over by a mile. This lends credence to my belief that the USD will be on a steep decline over the next 12-18 months. That's because each major bailout will depress USD. Paulson has to choose his words carefully in that he does not want a stampede out of USD or GSE debts and US Treasuries, but he obviously has little choice. Gonna have to negotiate my pay to be unpegged to USD...

photos: Pancake Khemanit