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Focus on Recession, Not Credit Crisis

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Earnings disappointments are only spreading further.

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Editor's Note: The below is reprinted with Mike O'Rourke's gracious permission from Bedtime with BTIG. Mr. O'Rourke is the BTIG Chief Market Strategist.

Someone in Washington has finally designed an intervention meant to reduce systemic risk.

During every instance of market malaise over the past year, Washington has administered a remedy in which 90% of the spoon was filled with sugar and only 10% was actual medicine. Secretary Paulson's latest plan to support the GSEs is akin to a dose that's 70% medicine and 30% sugar.

Let's just begin by reiterating what everyone knew: The government was going to backstop the debt regardless of the details of any plan. That's the key of this "conservatorship." The looming question was where the Treasury would draw the line on common and preferred shares.

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The answer is this: Secretary Paulson has gone as far as he possibly can without outright extinguishing the existing common and preferred shares. Treasury will receive newly issued warrants from the GSEs for 79.9% of the respective companies. As a result, be prepared for investors to potentially provide a 60%-80% haircut to the shares when trading resumes. Obviously, one needs to expect some short covering as well.

To us, the difference between the shares on Friday and the common and preferred shares today is that on Friday, the shareholders had call options; today, they have perpetual call options (albeit, likely at lower prices).

The term "perpetual" comes to mind because of Paulson's comments:

"Under these agreements, the Treasury will ensure that each company maintains a positive net worth...This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations... Because the GSEs are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking."

The plan keeps the existing shareholders alive - but in a long-dated coma. Should the business recover someday, there may be something there for them.

The critical component is the effort to reduce systemic risk. In 15 months, both companies will start a process by which they must sell 10% of their retained portfolio until they hit the $250 billion level.

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No positions in stocks mentioned.

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