Last Updated: March 13, 2008: 4:16 PM EDT
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Meet your new banker: Uncle Sam

Some say this year's financial sector upheaval could leave the feds buying stocks and bonds.

Colin Barr, senior writer

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Treasury Secretary Henry Paulson has been unusually candid in discussing the financial sector's pain.

NEW YORK (Fortune) -- With a vicious storm pelting the markets, Treasury Secretary Henry Paulson is urging bankers to batten down the hatches - possibly foreshadowing an expanded government role as a financial-sector investor.

Paulson spoke Thursday morning in Washington as the President's Working Group on Financial Markets unveiled its suggested policy responses to the past year's credit market unrest. Paulson said the group's recommendations - including stronger oversight of players in the mortgage industry - aim to make markets more transparent and less prone to breakdowns such as the one that began last summer, when investors began fleeing mortgage-related securities.

But the process of devising new regulations will inevitably take months and years to play out, as legislators and securities watchdogs debate which measures to adopt. In the meantime, financial institutions are under considerable stress. Bank and brokerge stocks have suffered steep declines over the past year, as asset prices have fallen and some leveraged players have been forced to sell at fire-sale prices.

Those facts haven't escaped the attention of Paulson, a former Goldman Sachs (GS, Fortune 500) executive. He warned investors in no uncertain terms Thursday to expect the ride to get even bumpier, as firms seek once again to bolster their balance sheets.

"We are encouraging financial institutions to continue to strengthen balance sheets by raising capital and revisiting dividend policies," he said in remarks addressed to the National Press Club. "We need these institutions to continue to lend and facilitate economic growth."

Trying to replace capital

The candid comments show that Paulson has come a long way since last summer, when he said to some derision that economic damage from the decline of U.S. house prices was "largely contained." Since then, shares in financial institutions with heavy exposure to housing-related debt, ranging from Fannie Mae (FNM) and Washington Mutual (WM, Fortune 500) to Bear Stearns (BSC, Fortune 500) and Citi (C, Fortune 500), have lost more than half their value amid worries about the declining value of their mortgage holdings.

The firms have already taken action to boost their capital, which has been depleted by big writedowns of deteriorating loans and derivatives holdings. Citi raised $30 billion in December and January, mostly by selling convertible preferred stock to deep-pocketed foreign investors. Fannie Mae raised almost $8 billion in a sale of preferred stock in December, while its government-sponsored mortgage-investing sibling Freddie Mac (FRE, Fortune 500) raised $6 billion the same way. Fannie and Freddie's regulator, the Office for Federal Housing Enterprise Oversight, recently deemed the firms adequately capitalized as of Dec. 31.

But that was before the latest downturn in the mortgage securities market. For months, investors have been shunning mortgage bonds issued by private-sector banks, fearing the bonds would lose value as home prices fall and defaults rise. Since last month, however, the market for so-called agency bonds - those issued by Fannie and Freddie, which carry the implicit backing of the government - has turned fearful as well. That's at least partly because President Bush recently signed into law a measure lifting the limits on the size of mortgages Fannie and Freddie can buy. Investors fear it will add to looming credit losses at the GSEs. Meanwhile, a steep drop in the value of the dollar, along with a bear market in U.S. financial stocks, may have reduced the appetite of many private investors to pour more capital into the banks.

Those dynamics have spurred a debate about how far the government should go in its efforts to keep big financial firms pumping money into the economy. David Merkel, chief economist at broker-dealer Finacorp Securities, believes the government - already having cut interest rates repeatedly and expanded the terms of its bank lending programs - might try to break the market panic by buying Fannie and Freddie's subordinated debt.

Feds may step in

A federal purchase of Fannie or Freddie debt could make sense for all involved if the securities convert into common stock or carry equity warrants. Merkel says a government purchase of, say, convertible subordinated debt would help the companies reliquefy their balance sheets while allowing taxpayers to participate in the gains of an eventual market recovery.

"In this environment, would the U.S. government step away from the mortgage agencies?" he asks in a recent post at his Aleph Blog. Of course not, he says, adding, "The agencies will need more capital for lending, so I would expect more preferred stock issues, and perhaps an equity issuance, if to a key investor, like the U.S. government."

The sight of the government taking a stake in a private company will raise hackles among those who believe the feds should minimize their involvement in the economy. But the feds have done so before: several airlines that filed for Chapter 11 bankruptcy protection after the Sept. 11, 2001, terror attacks issued warrants to the government as part of their plans to re-emerge as public companies.

Dean Baker, co-director of the Center for Economic and Policy Research, notes that Fannie and Freddie's very existence is predicated on the favorable rates they borrow at due to the implicit government guarantee of their bonds. The firms "would be bankrupt otherwise," Baker says. He adds that possible federal efforts to recapitalize Fannie and Freddie are understandable as part of an attempt to avert a "cascading effect" started by debt-market failures.

That's very much the thinking of Nobel-winning economist Myron Scholes, who tells The Wall Street Journal that the government should be looking to buy into all sorts of private-sector financial firms. Thursday's David Wessel column finds Scholes advocating that the feds invest in senior debt and senior preferred stock, to avoid favoring one class of existing investors over another - and to avoid a rash of bank liquidations that slow the economy by reducing lending.

Whatever course policymakers choose, it's unlikely to be one everyone is happy with, as Paulson suggested in Thursday's question-and-answer session at the National Press Club. "This is a real challenge," he said of the effort to make regulation more robust without crimping private-sector innovation. "These large global institutions are not easy to manage."  To top of page

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