Sunday, July 13, 2008

Treasury, Fed Affirm Backing For Ailing Mortgage Giants

(WSJ) The U.S. Treasury and Federal Reserve, capping a weekend of high-stakes maneuvering, attempted to shore up confidence in Fannie Mae and Freddie Mac by announcing a plan that placed the federal government firmly behind the battered mortgage giants.

In a statement timed to precede the opening of Asian markets Monday, as well as a closely watched auction of debt by Freddie, the Treasury said it plans to seek approval from Congress for a temporary increase in a longstanding Treasury line of credit for the two companies.

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The Treasury also said it would seek temporary authority so that it could buy equity in either company "if needed" to ensure they have "sufficient capital to continue to serve their mission" of providing a steady flow of money into home mortgages. The plan, which requires congressional approval, also calls for a provision to give the Federal Reserve a "consultative role" in the process of setting capital requirements and other "prudential standards" for Fannie and Freddie.

The Fed's Board of Governors met Sunday in Washington and voted to grant the New York Fed authority to lend to Fannie Mae and Freddie Mac "should such lending prove necessary," the central bank said in a statement. The move would effectively give the two companies access to the Fed's discount window if necessary, providing a backstop in case the firms were to face a short-term funding crisis down the road.

Officials are hoping that, by promising bold action if needed, they can instill enough confidence in the battered companies that such intervention will ultimately prove unnecessary.

Buying Bank Loans

Fannie and Freddie are the nation's dominant providers of funding for home mortgages. They buy loans after they are made by banks, package most of them into securities, and sell many of them to investors all over the world.

The moves reinforced the notion that investors can always count on the government to bail out Fannie or Freddie in a crisis -- a belief the Bush administration until recently tried hard to quash.

The moves highlight Treasury's concern about market conditions. A senior official said the steps are intended to help "stabilize" the current situation. While Treasury does not think the financial situation of either firm has deteriorated since Friday, "as we've watched market developments, we decided it was time for policy makers to act," said one administration official.

Surge in Defaults

The government is relying heavily on the two companies to prop up the U.S. mortgage and housing markets, weakened by a surge in mortgage defaults over the past two years. If either company ran into serious financial trouble -- a prospect that seemed more real last week when their stocks fell nearly 50% -- it would be a blow to the already weak housing market and economy.

The weekend move means that Fed Chairman Ben Bernanke, who has been steadily accumulating authority as the U.S. grapples with the financial crisis, will have even more power. The Treasury envisions the Fed working with the mortgage giants' regulator to help prevent situations that could be a risk for the entire financial system. The move builds on Treasury's broader goal of remaking financial regulation to give the Fed broader influence over financial-market stability.

[Fannie Mae]
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Fannie Mae headquarters in Washington, D.C.

Federal regulators, politicians and investment banks spent two hectic days swapping information and seeking ways to calm markets. From Washington, Treasury Secretary Henry Paulson called the heads of some investment banks, trying to gauge the level of nervousness about Fannie Mae and Freddie Mac and to determine whether the banks would participate in Monday's $3 billion debt auction, according to people familiar with the matter. Timothy Geithner, president of the Federal Reserve Bank of New York, also has been reaching out to Wall Street firms over the weekend to discuss the latest events.

Fed, Treasury and company officials stayed in touch with top Capitol Hill lawmakers and their staffs throughout the weekend. Lawmakers continued their efforts to reassure financial markets about the government's support of both companies.

Fannie Mae Chief Executive Officer Daniel Mudd expressed gratitude for the government's actions. "Given the market turmoil, having options to access provisional sources of liquidity if needed will help to strengthen overall confidence in the market," he said.

If either company asks for it, it could have access to a line of credit or an equity investment by the U.S. government. Both the line of credit and the liquidity backstop would be temporary, but could be in place for up to 18 months. Treasury would not say how high the line of credit might go, or how much of an equity stake Treasury might purchase. The agency would not discuss whether the equity stake would carry any preferred terms for the government. Those decisions would be up Mr. Paulson, the official said, and "will be governed by protecting the taxpayers and the government."

The two companies' lines of credit are currently capped at $2.25 billion each. The Treasury didn't say to what level they would be increased. It's also not clear what role the Fed might play.

Much of the changes would require congressional approval, although lawmakers appear ready to act quickly. Late Friday, the Senate passed a housing package that would create a new, stronger regulator for Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks. The House passed a similar bill in May, but the process since then has been stalled by complications.

Legislation Under Way

The bill could pick up speed now. Lawmakers only need to resolve a few differences, and potentially to add the changes. House Financial Services Committee Chairman Barney Frank (D., Mass.) said he spoke with Mr. Paulson several times over the weekend and was "generally supportive" of the proposals. He said all sides would have to discuss the details of the plan, but he felt optimistic that a consensus could be reached quickly. "This could be on the president's desk next week," he said.

The administration official said Mr. Paulson has reached out to members of Congress and has had "good productive conversations....There's nothing to suggest that we will not be able to accomplish this."

The Sunday move was designed in part to head off fears about Monday's auction of Freddie Mac notes. While small, the planned sale had assumed an outsized importance as a test of investor confidence. Freddie should be able to find buyers for its three- and six-month notes, market analysts said. But there is a chance that some financial institutions and investors may demand higher-then-usual yields.

Similar Freddie and Fannie notes that are currently outstanding yield around 2.5%. If weak demand for Freddie's auction leads to sharply higher yields on the new notes, that could trigger a selloff across a wide range of debt issued by the companies, some analysts said. But most said such a scenario is unlikely.

Hybrid Companies

There was some debate within the administration about the best way to handle the two companies, which are a hybrid -- public companies with implicit government backing. Some Republicans have long worried that taxpayers would eventually be on the hook for risks taken by the two companies on behalf of shareholders.

Some officials at the White House are believed to have preferred a tough-love approach. Under one option, according to people familiar with the outlines of policy discussions within the administration, the White House could try to install a new slate of presidentially appointed board members at the companies. The idea would be to impose more market discipline on the two companies, to curb their appetites for borrowing and investing, and to gradually shrink their enormous balance sheets.

In the past, that's proved hard for the government to do, because of the companies' relatively weak regulator and their perceived financial backing from the federal government, which allows them to borrow easily, at low cost. But as the housing market has worsened in recent months, Congress and the administration have come to depend even more on Fannie and Freddie. Reducing the two companies' ability to fund mortgages could hurt the housing market further, and delay recovery.

Appointment of new presidential directors would be an abandonment -- at least for now -- of the Bush administration's often-stated ambition to distance the federal government from the companies. The new board members would be drawn from the ranks of financial-market heavyweights.

Shares' Plunge

Fannie and Freddie shares both dropped about 45% last week and are down more than 80% over the past year. Investors are worried that the companies eventually will have to raise large amounts of capital to cope with growing losses stemming from mortgage defaults. Freddie has announced plans to raise $5.5 billion by selling common and preferred shares, but it is likely to wait for a calmer market. Fannie raised $7.4 billion in share offerings in April and May.

Fannie and Freddie were chartered by Congress to ensure a steady flow of money into home mortgages. But they are owned shareholders, and their shares are listed on the New York Stock Exchange. The two companies own or guarantee about $5.2 trillion of U.S. home mortgages, nearly half of all mortgages outstanding.

There have long been legal provisions that authorize the Treasury to buy as much as $2.25 billion of Fannie or Freddie debt. This generally has been viewed as a symbol of the companies' ties to the government, rather than something they were likely to use.

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