'The Game Is Over'

Markets have lost confidence in Fannie and Freddie. It's time for Treasury to step in.

WHEN TREASURY Secretary Henry M. Paulson Jr. unveiled his rescue plan for Fannie Mae and Freddie Mac in mid-July, he argued that the massive potential costs would never materialize. The mere pledge of government backing for the two mortgage giants would restore market confidence, Mr. Paulson said, making it easier for them to raise much-needed capital and to continue borrowing at favorable rates. It has taken a little more than a month for the markets to call Mr. Paulson's bluff. Over the past week, the companies' paltry remaining market capitalization has been nearly wiped out. More ominous, the companies are being forced to pay higher interest rates on their bonds.

Company executives grumble about alleged government leaks designed to spoil their image among investors. From where we sit, it looks as if the markets are reacting to bitter realities, including a Post story by David S. Hilzenrath that appeared Tuesday documenting Fannie Mae's risky plunge into the subprime and "Alt-A" mortgage markets during 2006 and 2007.

The firm now owns or guarantees $388.3 billion worth of the stuff. To be sure, these are relatively high-quality subprime and Alt-A loans, but there are still bound to be a lot of duds

included.

The bottom line is pretty clear: Housing prices are falling; no one knows how far or for how long. So the two firms are likely to lose billions. That gives them little or no prospect of raising enough private capital to bolster their perilously thin resources. If they also can't borrow extra-cheaply and pass those savings on to home buyers, the very reason for their special status as "government-sponsored enterprises" is in doubt. As investor Warren Buffett observed yesterday, "The game is over."

Fannie and Freddie own or guarantee half of the $12 trillion U.S. mortgage market. Central banks all over the world, and commercial banks all over America, hold their bonds. Therefore, they must be enabled to operate normally in the short term. Congress has given Mr. Paulson broad authority to keep them going with government money, and he should use it -- sooner rather than later. Prolonging the agony will only increase the cost of the inevitable government rescue, which the Congressional Budget Office has very conservatively estimated at $25 billion.

Such a bailout could prove even more complicated than the savings and loan rescue of the 1980s and 1990s. Yet it could be accomplished if Mr. Paulson got it off to a good start. Step one would be to calm the markets by explicitly pledging government support for Fannie Mae and Freddie Mac's own bonds and the mortgage debt they guarantee. Step two would be to give the two corporations enough capital to survive until the housing market touched bottom. In return, the federal government would get control over the companies, wiping out their existing shareholders (who are almost wiped out already) and ousting their management.

There is no shortage of suggestions for what should happen next. Lawrence H. Summers, a Treasury secretary during the Clinton administration, has proposed a transitional period of government operation followed by the companies' division into government and private components, the latter to be sold off in pieces. The only option that must be ruled out is a return to the hybrid "government-sponsored" business model in which taxpayers implicitly subsidized the companies' risk-taking. That game is, indeed, over.