Fannie and Freddie: why the takeover

Treasury said Sunday the mortgage giants will enter a conservatorship.

By , Staff writer of The Christian Science Monitor

By taking control of Fannie Mae and Freddie Mac, the Bush administration has launched a high-stakes bid to bolster the housing market and the US economy – seeking to minimize costs to taxpayers even as it puts them on the hook.

Treasury Secretary Henry Paulson on Sunday announced a federal conservatorship for the two mortgage giants, which play a key role in the housing market, now rocked by falling home values and high rates of foreclosure.

The action begins a formal Treasury role that, just a few weeks ago, Secretary Paulson said he expected to avoid. Fannie and Freddie, as private companies created by government mandate, have long been seen as implicitly backed by the Treasury. Now that backstop is as explicit as it can be.

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Why is it coming to this?

The short answer is that legislation Congress passed in July failed to reassure financial markets enough to position the two companies to raise needed capital on their own. That law gave the Treasury new authority to funnel credit or capital into Fannie and Freddie, if needed – at taxpayer expense.

Meanwhile, foreclosures continue to pummel the mortgage firms with big losses.

"It's going to get worse if they don't act," says Peter Morici, an economist at the University of Maryland. "We want this dealt with now."

The two companies will now operate, as they open their doors Monday, under the authority of the Federal Housing Finance Agency (FHFA), a new agency that Congress created this summer to regulate Fannie and Freddie.

Paulson announced the conservatorship along with James Lockhart, the FHFA's director. He outlined three key goals: ensuring market stability, continuing the availability of mortgages, and holding taxpayer costs to a minimum.

Those goals, he said, could not have been achieved by simply pumping federal money into the two companies in their present form.

An impetus for Sunday's move is what Paulson described as ambiguity in the identity of the two so-called government-sponsored enterprises (GSEs). For years they have operated with both a public mission – to foster broad and stable mortgage markets – and a private one of providing profits for shareholders.

The goal of maximizing shareholders' returns, Paulson said, has "encouraged risk-taking."

Given the plunge in share value at the GSEs during the past year, the worry was that their managers might have been tempted to take on more risk in an effort to recover.

"The shareholders have nothing to lose and everything to gain" if Fannie and Freddie's CEOs were to take new risks now, because the current share price is so low, says Morris Davis, a University of Wisconsin economist who focuses on real estate issues.

In the 1980s, he says, the savings and loan industry got into trouble because regulators and Congress allowed such a pattern to play out.

Fannie Mae and Freddie Mac have a central role in the housing market, with their odd names representing shorthand for longer titles including the words "federal" and "mortgage." The duo fuels home lending by purchasing loans from other lenders, or by providing guarantees to back the share of mortgage loans that meet their standards. The guarantees give investors confidence to buy packages of mortgage debt, known as mortgage-backed securities.

Those actions can keep loans flowing even when, as now, many traditional banks are reluctant or unable to make home loans and hold them on their own books. Currently, most mortgages in the US flow through Fannie or Freddie, and nearly half of all outstanding mortgage debt is linked to them in some way.

Their role in the housing market has long been controversial, but in the current weak economy their outright failure is unthinkable for most policymakers.

The conservatorship represents a temporary step, akin to a bankruptcy from which the GSEs will ultimately emerge. Next year, Paulson said, the next US president and Congress will have to determine the firms' longer-term structure and size. Ultimately, Paulson said, "government support needs to be either explicit or nonexistent."

For now, however, the focus is on improving the economic and credit climate.

Mr. Lockhart and Paulson detailed a multipronged plan for Fannie and Freddie in the near term:

•The firms will continue to make loans "without limits," at a time when mainstream banks have tightened lending standards or raised interest rates.

•They will stop paying shareholder dividends, conserving $2 billion a year.

•They will have access to a line of credit from the Treasury, if needed.

•The Treasury will become an investor in preferred shares and warrants of the GSEs, with a position senior to current investors. The size and timing of investments will be as needed to maintain a positive net worth for the enterprises.

•The Treasury will be a buyer of new GSE-issued mortgage-backed securities, a move designed to help keep mortgage rates low.

•The firms' chief executives, Daniel Mudd and Richard Syron, will be replaced, but will stay for a transition period. Herb Allison, a former Merrill Lynch executive, will head Fannie Mae, and former banker David Moffett will head Freddie Mac. The incoming CEOs, as public employees, will have much lower salaries.

•Political lobbying efforts, long a source of GSE clout on Capitol Hill, will cease. Charitable giving will be reviewed.

Paulson said he expects the purchase of GSE debt would come at no cost, and possibly at a profit, to taxpayers. But the overall taxpayer cost of the intervention would depend on business conditions going forward, he said Sunday.

"I have long said the housing correction poses the biggest risk to our economy," Paulson said.

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