Treasury to Rescue Fannie and Freddie
Regulators Seek to Keep Firms' Troubles From Setting Off Wave of Bank Failures

By Zachary A. Goldfarb, David Cho and Binyamin Appelbaum
Washington Post Staff Writers
Sunday, September 7, 2008

The Bush administration yesterday prepared to take over the troubled housing finance companies Fannie Mae and Freddie Mac, after concluding the companies don't have enough capital to continue to play their crucial role funding home mortgages.

Under the plan, engineered by Treasury Secretary Henry M. Paulson Jr., the government would place the two companies under "conservatorship," a legal status akin to Chapter 11 bankruptcy. Their boards and chief executives would be fired and a government agency, the Federal Housing Finance Agency, would appoint new chief executives.

The action, which would be one of the most sweeping government interventions in private financial markets in decades, is planned for today, according to several sources.

Authorities see Fannie Mae and Freddie Mac as crucial to the recovery of the housing market. They have funded 70 percent of home loans in recent months. A reduction in their activities could send mortgage rates that ordinary home buyers pay soaring and result in a new, deeper crisis for the already reeling housing market.

Moreover, regulators are trying to prevent Fannie Mae and Freddie Mac's problems from triggering a new wave of failures among banks, which hold vast reserves of bonds and preferred shares issued by the two firms.

The plan would not resolve the larger question about the future of the two companies -- whether they should be nationalized, privatized or maintain their current structure. Those options have been intensely debated within the government and among financial experts. Some proposals would dramatically change how home mortgages are funded in this country.

Paulson and other government officials decided to act before those more complex issue were decided because of fears that Fannie and Freddie's ability to make cash available for home loans would face serious challenges in coming weeks. Sources said the plan is to leave the more sensitive policy decisions to Congress and the next administration.

Paulson briefed congressional leaders and presidential candidates John McCain yesterday and Barack Obama on Friday night. Obama yesterday said that he approves of the government action, if it does not bail out the companies' shareholders and executives and is good for the economy. Republican vice presidential nominee Sarah Palin said a McCain administration would make the companies smaller and more effective.

With foreclosures rising and the government bailout expected, Fannie and Freddie have had problems raising more capital. "It's a case where market psychology became more important than the fundamentals, and that's why they had to act," said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee. "There's no immediate crisis. It's not like they're going to run out of money tomorrow or Monday. It's a decision that the market is simply not going to accept the status quo."

Officials at the Treasury Department, working with investment bankers from Morgan Stanley, concluded that neither company has enough money to weather the crisis, according to sources. They said, for example, that much of the capital on Freddie's books is in "deferred tax credits," which would be worthless if the firms do not make a profit in the coming years, just as an individual cannot claim a tax credit if he has no income.

Paulson concluded in recent weeks that even a one-time infusion of government cash would not be enough to restore investor confidence unless it represented a truly massive amount of cash, which he was reluctant to commit. He told Federal Reserve Chairman Ben S. Bernanke and Federal Housing Finance Agency director James Lockhart of that conclusion early this week.

Both companies have agreed to the takeover, sources said. Executives of the two firms met with Paulson and Bernanke yesterday.

Instead of making a one-time cash infusion to keep the companies afloat, the government will make quarterly investments, to the degree that market conditions require. That way, in Treasury officials' view, investors can have confidence of a ready source of cash if the firms need it, but taxpayers need not be put on the hook anymore than necessary. The companies' shares are off about 90 percent from their highs in the past year.

The impact of the Treasury plan on stockholders in the two companies remains unclear. The conservatorship itself would not affect the value of shares. That would only happen as Treasury actually pumps money into the companies.

If the companies perform well in coming months, the government will not have to invest much money, if any, and shareholders will not suffer much. If the companies perform poorly and the government makes massive infusions, shareholders could lose their shirts.

The Treasury Department has told banking industry representatives and members of Congress that it is sensitive to concerns that a wipeout of shareholders' value could damage the viability of many banks.

The government could choose to reduce the value of the shares, for example by suspending dividend payments. One industry expert said a possible model could be the bailout of Continental Illinois, the largest banking bailout in the 1980s. In that case, the government gave shareholders a 20 percent stake in the company, which it then reduced as losses grew.

Fannie Mae was created during the Great Depression as a government support for home mortgage lending. In 1968, Congress spun it off as a hybrid for-profit and government enterprise, meaning it has both a government policy mission -- to support affordable housing and homeownership -- and a profit motive. Soon after, it created Freddie Mac in the same mold. The companies are not required to pay state and local income taxes. However, their shares are also listed on the New York Stock Exchange, and they pay their top executives multimillion dollar salaries.

Fannie Mae, based in an elegant brick headquarters on Wisconsin Avenue in Northwest Washington, and Freddie Mac, based in an office park in McLean, buy mortgages from banks, hold on to some and package others that they sell to investors around the world. This year they have funded more than two-thirds of new mortgages.

For years, they played high-profile roles in the political and civic life of Washington, hiring armies of lobbyists to help protect their unique status and, through foundations, giving vast amounts of money to charities large and small. That began changing with a series of accounting scandals beginning in 2003. The housing crisis raised more questions about their structure and operations.

Obama yesterday said any rescue plan must "not bail out the shareholders and management of Fannie Mae and Freddie Mac," though he noted the wide exposure of community and regional banks to the companies' shares. He said the plan must clarify "the true public and private status" of the companies. He also said it must be good for the overall economy.

McCain said that the times are "tough" and that "today we're looking at a federal bailout of our home loan agencies."

Palin said: "The fact is that Fannie Mae and Freddie Mac have gotten too big and too expensive to the taxpayers. A McCain-Palin administration will make them smaller, and smarter and more effective for the homeowners they help."

Staff writers David S. Hilzenrath, Neil Irwin, Michael D. Shear, with McCain and Palin, and Peter Slevin, with Obama, contributed to this report.

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