Market Welcomes Takeover
Stocks Rebound; Critics Question Need for Bailout

By Zachary A. Goldfarb and Neil Irwin
Washington Post Staff Writers
Tuesday, September 9, 2008

Financial markets soared and mortgage rates fell yesterday after Sunday's government takeover of housing finance giants Fannie Mae and Freddie Mac, but shares in the two companies lost almost all their value.

The action stabilized a wide range of debt markets, whose frazzled state endangered the U.S. and world economies. But analysts cautioned that there can be no certainty that the spiraling financial crisis is nearing an end.

The move drew praise from Wall Street and banks around the world. Dissenting voices, however, questioned whether the rescue was necessary and whether it exposed taxpayers to vast potential costs.

Even as the debate over the takeover began, the new chief executives arrived at the campuses of Fannie Mae in the District and Freddie Mac in McLean and set about the challenging task of expanding their funding of mortgages in the near term and protecting taxpayers from losses in the long term.

The government's plan, engineered by Treasury Secretary Henry M. Paulson Jr., put Fannie Mae and Freddie Mac under control of their direct federal regulator. It also involved replacing the chief executives, extending a line of credit to each company and buying $5 billion in securities backed by mortgage loans to drive down mortgage rates. The companies, battered by the mortgage meltdown, had been suffering billions of dollars of losses, putting their survival at risk.

Once among the biggest companies in the country, Fannie Mae and Freddie Mac are now penny stocks: Fannie Mae closed at 73 cents a share, down 90 percent yesterday, and Freddie Mac shares went for 88 cents, down 83 percent.

The government's action appeared to encourage buyers of mortgage bonds issued by Fannie Mae and Freddie Mac, which in turn should lower the rates Americans pay for home loans.

Stocks rallied in response to the plan. The Dow Jones industrial average jumped 2.6 percent, to 11,510.74. The broader Standard & Poor's 500-stock index rose more than 2 percent, to 1267.79. Leading the rally were home builders, banks and other companies whose fortunes are closely linked to the general health of the housing market.

But portfolio managers warned that unresolved concerns about the state of the economy could undercut the rally.

"The market is always looking for silver linings," said Harry Clark, who runs Philadelphia-based Clark Capital Management. "I think they'll wind up giving [the gains] back a couple of days from now."

On Capitol Hill, Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.) said he will summon Paulson to appear this week before his panel to explain why he decided to seize the companies less than two months after assuring lawmakers that no such action would be necessary. Dodd complained that just months ago, Paulson was saying he wouldn't need to use the authority Congress granted him to inject capital into the companies.

"We certainly accepted him at his word that that was all that was going to be necessary," Dodd told reporters, adding that he planned to be "more cautious" about granting Paulson's future requests. "Fool me once, your fault. Fool me twice, my fault. Is this action going to produce the desired results, or are there other actions being contemplated?"

The fine print of the plan could contribute to new risks. For example, the government decided to protect investors in "subordinate" debt in Fannie Mae and Freddie Mac -- investors who had agreed to take on more risk and higher returns.

"What I worry about here is that subordinated debt holders of other truly private banks may start to think they will also be protected if their banks fail," said Douglas W. Elmendorf, a senior fellow at the Brookings Institution.

Government officials behind the takeover believed they had to protect debt holders. Otherwise the companies would have had massive numbers of creditors demanding to be paid back immediately.

The Treasury's move triggered one of the largest defaults in history for the $60 trillion market for credit default swaps. These are privately tradable instruments that allow investors to make side bets on the likelihood a company will default on its bonds. Even though Fannie Mae's and Freddie Mac's bonds were protected in the rescue plan, the companies' transition into conservatorship was the equivalent of a bankruptcy for credit default swap traders, according to the International Swaps and Derivatives Association.

An estimated $1.4 trillion worth of credit default swaps is traded on Fannie Mae and Freddie Mac's bonds, according to Bloomberg.

The Federal Housing Finance Agency, the regulator that will run Fannie Mae and Freddie Mac, continued to hammer out details yesterday about how the companies would operate under its control.

Government officials said the companies would probably expand their lending programs to make mortgages available to more borrowers. The companies had curtailed lending in recent months as their financial condition worsened. "The companies were starting to contract, and that was not very useful. One of the things we can do is serve this mortgage market better," said an official who spoke on condition of anonymity because the government was still working out details with the companies. "They were having trouble fulfilling this mission."

For now, the agency will play a large role in shaping decisions at Fannie Mae and Freddie Mac. But the government official said that over time, the companies' new chief executives would have greater independence, and the regulator would return to its role of just monitoring the companies' books. The agency is "going to fade back to being the examiner," the official said.

Government officials emphasized that the Federal Housing Finance Agency, and not the Treasury Department, would be in the driver's seat.

New Freddie Mac chief executive David Moffett and Fannie Mae's new chief executive Herb Allison, longtime industry officials named by the government to run the companies, held meetings yesterday to talk about the companies' plans.

At a staff meeting with several hundred employees at Fannie Mae headquarters in Northwest Washington, Allison was asked whether there would be layoffs. Jobs are secure, he said, according to a person familiar with the meeting.

Immediate layoffs are not expected at Freddie Mac, either. The firms will continue to pay the same salaries, benefits and pensions to employees, though the federal regulator and new management are examining whether to revise the compensation system. No decisions have been made about the companies' boards.

The departing chief executives, Richard Syron of Freddie Mac and Daniel Mudd of Fannie Mae, are remaining with the companies for a transition period. Mudd and Syron were told in meetings with senior government officials on Friday that they would have to step down.

Paulson believed they had to be fired to send a signal that the top people at both firms were being held accountable for the companies' troubles, government officials said. Syron had already been planning to leave the company.

News of the takeover sent a chill through the nonprofit world. The companies have put millions of dollars into local charitable organizations -- something the government said was being reviewed.

"The possibility that they might disappear from the philanthropic scene is making people even more nervous," said Lindsey Buss, president of Martha's Table, a District nonprofit group. Buss said he hadn't spoken with his usual contacts at Freddie Mac and Fannie Mae. "I don't feel comfortable calling right now," Buss said. "They're probably wondering if they have jobs."

Staff writers Lori Montgomery, David Cho, Kendra Marr and Heather Landy in New York contributed to this report.

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