Stock Markets Soar After Freddie, Fannie Bailouts

By Howard Schneider and Ariana Eunjung Cha
Washington Post Staff Writers
Monday, September 8, 2008 5:11 PM

U.S. stock markets surged higher today as investors expressed confidence that the government's weekend seizure of Fannie Mae and Freddie Mac would bolster the slumping U.S. housing and mortgage markets.

Shares in the companies themselves, meanwhile, plummeted toward penny stock range, undermined by a government takeover that puts the rights of bondholders and the U.S. Treasury above those of common and preferred stockholders. Shares in both companies each fell by more than 80 percent. Freddie ended the day at 88 cents a share, an 83 percent decline, and Fannie closed at 73 cents, a 90 percent decline.

Following rallies that pushed Asian and European indexes up as much as 4.5 percent, the Dow Jones industrial average jumped more than 330 points in early trading and closed up 290 points at 11,511. That was a 2.6 percent gain for the day.

The Standard & Poor's 500-stock index was also up about 2 percent with a 25-point rise to 1,268.

The Nasdaq composite index climbed 14 points to 2,270, a more modest gain of 0.6 percent.

The rally provided at least an initial vote of confidence in the plan announced yesterday by Treasury Secretary Henry M. Paulson Jr. to place the two mortgage giants into a government-managed conservatorship while a longer-term restructuring is ironed out. Central bankers in Beijing and Tokyo -- important buyers of U.S. mortgage-backed debt -- also came out in support of the takeover, which includes U.S. government guarantees that their billions of dollars in bonds will be repaid.

In an interview on CNBC this morning, Paulson said seizing control of the two companies was "not something I wanted to do" but was unavoidable given the havoc the failure of either firm would have caused to the U.S. and global economies. Fannie and Freddie are critical to the functioning of U.S. mortgage markets, but there have been growing doubts about their ability to fill that role.

"This is not something you are happy about," Paulson said, but "it was better than the next best alternative."

Stock markets, however, were ecstatic, with shares in banks and financial companies leading major world indexes sharply higher. On Wall Street, Citigroup and Bank of America were up as much as 10 percent at one point.

The financial sector has been hit hard by rising U.S. mortgage defaults, with companies trimming tens of billions of dollars from their balance sheets to account for the falling estimated value of mortgage-backed investments.

By boosting hopes of a stabilized U.S. mortgage market, the takeover of Fannie and Freddie raised the prospect that the cycle of markdowns also might be close to an end. Details of the takeover plan are still to be worked out, but in general it means the federal government will now ensure the companies have the capital to continue funding mortgages and -- as important to the markets -- will guarantee repayment of the bonds and other forms of debt issued by them.

The cost to taxpayers is not known, Paulson said. The U.S. Treasury might even make money by directly buying mortgage-backed securities, a step taken to ensure the market continues functioning for that and other types of debt that help keep the mortgage markets fueled with cash, he said.

"We did not sit down and figure this out with a calculator," Paulson told CNBC, because the stability of the financial markets seemed the more important issue. "This is about our financial markets, confidence in our financial markets."

The takeover of the two companies "should take a lot of uncertainty out of the market in one quick move," trader Matt Buckland, at CMC Markets in London, told the Bloomberg news service.

Central banks in Asia have been major investors in Fannie and Freddie securities, and the extension of an explicit U.S. government guarantee to that debt was heralded in Tokyo and Beijing.

"We expect the action would lead to stabilize the U.S. [mortgage-backed securities] market, financial market and the international financial market," Bank of Japan head Masaaki Shirakawa said at a meeting in Switzerland, the Reuters wire service reported.

"From my point of view this is positive," said Zhou Xiaochuan, governor of China's central bank.

Asian banks had begun curbing their purchases of Fannie and Freddie securities, and investors generally had been insisting on higher interest rates -- driving up the company's operating costs and pushing mortgage rates higher. Officials hope the takeover plan will reverse that trend, and could help revive the housing market by lowering the cost of borrowing.

In the CNBC interview, Paulson said the growing concern of foreign investors about the health of Fannie and Freddie was among the things that prompted him to take action.

"There was definitely concern overseas," Paulson said. Foreign investors "have reduced their level of buying and some had stopped buying and there was some selling. . . . This was just obvious."

An estimated $376 billion in Fannie and Freddie debt is held in Asia. In the past few days, officials at China's four largest publicly listed banks said that they held a combined $23.28 billion of debt issued or guaranteed by the U.S. lenders as of the end of June but that they had been reducing their stakes in Fannie and Freddie.

The outcome of the takeover for Fannie and Freddie stockholders is less certain. Once viewed as a safe bet, with a business model implicitly backed by the U.S. government, shares in the two companies have plummeted this year as concerns increased about their ability to continue functioning.

The government takeover halts dividend payments to stockholders and provides no guarantees that shares in the company will hold their value.

Paulson, in the CNBC interview, said that even though the final structure of Fannie and Freddie remains to be worked out, the terms of the government takeover will put the interests of taxpayers ahead of stockholders.

"If and when we put money in, the taxpayers will be protected and the government will be repaid before the shareholders get a penny," he said.

Despite the short term boost for equity markets, officials and analysts were split on the long-term implications of the takeover.

In a CNBC interview, James B. Lockhart III, head of the federal agency that oversees the two companies, said the takeover should bring down U.S. mortgage rates and help the housing market recover -- a potentially important step in reviving the economy more broadly. The current economic slowdown has pushed unemployment above 6 percent; wages have stagnated even as prices continue to rise; and declining home values have undercut household wealth.

"If these companies had been allowed to spin out of control, it could have been a lot worse," Lockhart said. "Hopefully this action we took will help the housing market recover and we might start to see some stabilization."

Geng Qun, head of global research for Bank of China, said that the Treasury plan is good news for Fannie and Freddie but that it's still too early to say anything about how this will affect the U.S. economy as a whole.

"Delinquencies and foreclosures are still going up. Even though the U.S. government is intervening, the economy is worsening," Geng said. But Geng said he did believe the intervention by the Treasury Department will stop Chinese banks from further reducing their holdings in Fannie and Freddie.

"By looking at it from the credit risk point of view, they won't need to sell anymore. In general, it's a good thing," she said.

Samuel Chen, vice president for banks and financial services for J.P. Morgan Hong Kong, said the Treasury takeover was expected so the market rally in Asia might only be temporary. Under the current plan, it's still possible "shareholders will still lose a lot. Their shares will be significantly diluted."

Cha reported from Shanghai.