Treasury takes over Fannie, Freddie

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The Treasury Department on Sunday seized control of Fannie Mae and Freddie Mac in an effort to stabilize the mortgage and global finance markets, opening the door for what likely is to be a major restructuring and downsizing of the mortgage giants in the next administration.

While the massive and unprecedented takeover appears set to become the largest financial bailout in history, Treasury Secretary Henry M. Paulson Jr. said his immediate goal simply is to preserve the companies largely in their current form as quasi-governmental agencies and keep them solvent until Congress and the new president can decide how to change them in the long term.

“The new Congress and the next administration must decide what role government in general, and these entities in particular, should play in the housing market,” he said. “There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form … . Only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission.”

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For now, he said the Treasury’s plan to infuse up to $200 billion of cash into the mortgage giants through a complicated series of moves designed to protect the interests of taxpayers was necessary to prevent a potential collapse in the housing and finance markets from pulling down the rest of the economy.

“Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe,” Mr. Paulson said.

A breakdown at Fannie or Freddie would have had broad ramifications for the economy, he said, not only making home loans scarce but making auto and other consumer loans harder to get. He said it also would have diminished household wealth and savings by putting further pressure on home prices. Homes represent the biggest investment of most Americans.

Under the financing scheme set in motion Sunday, the Treasury and the Federal Housing Finance Agency will take over Fannie and Freddie under a so-called conservatorship, replacing their chief executives and eliminating their stock dividends.

The Treasury will purchase up to $100 billion of senior preferred stock in each company as needed to maintain a positive net worth. It also will provide short-term funding to Fannie, Freddie and 12 federal home-loan banks, and purchase $5 billion of their guaranteed mortgage bonds by the end of this month.

The government appointed new management at the agencies: Herbert Allison, former chief executive of pension fund TIAA-CREF, will take over as Fannie’s new CEO, while David Moffett, who used to serve as vice chairman of U.S. Bancorp, will head Freddie. The current CEOs of Fannie and Freddie, Daniel Mudd and Richard Syron, respectively, will serve as consultants in a transition period.

Mr. Paulson insisted that, despite the $200 billion of funds the Treasury is prepared to give Fannie and Freddie under the plan, taxpayers need not pay a price if the plan proves effective and enables the housing and mortgage markets to recover. In that case, he said, Treasury might make a profit from its investments.

James Lockhart, the housing finance agency’s director, said Sunday’s action was necessary because the companies were having trouble raising money on their own and could not “continue to operate safely and soundly and fulfill their critical public mission without significant action.” Market confidence in the companies will be tested as they roll over an estimated $225 billion in debt before the end of the month.

One area that will be cut back immediately is lobbying and other political activities, which Mr. Lockhart said must cease. Officials at Fannie and Freddie, which are major employers in the Washington area, declined to comment. Company employees are scheduled to meet with the new executives Monday morning.

The temporary takeover will last until the end of next year, giving the next administration and Congress time to decide whether to continue it and what to do with the agencies in the long term.

The Treasury took a step toward long-term restructuring and downsizing of the companies by requiring them, as a condition of receiving Treasury’s stock investment, to gradually pare down huge portfolios of mortgage loans they have purchased as part of their massive money-making operations in recent years.

Fannie and Freddie would be allowed to increase their portfolios until the end of next year from about $750 billion apiece today to no more than $850 billion. But after that, they would be required to run down the portfolios by 10 percent a year for about a decade until they reach $250 billion apiece.

The planned downsizing of the companies appears in sync with the policies of Republican presidential candidate Sen. John McCain, who has said he wants the agencies to be smaller and more effective.

“Senator McCain thinks that this is a step in the right direction, and we need to protect the taxpayers, and we need to never allow this to happen again,” McCain adviser Nancy Pfotenhauer said Sunday on CNN’s “Late Edition.”

Democratic presidential candidate Sen. Barack Obama has been supportive of the takeover plan, but has not indicated whether he would cut back the agencies or enhance their roles in the housing market.

“Once we ride out the current crisis, the plan must move toward clarifying the true public and private status of our housing policies,” he said Sunday, suggesting that the government’s role shouldn’t only be to provide a bailout. “In our market system, investors must not be allowed to believe that they can invest in a ‘heads they win, tails they don’t lose’ situation.”

The Treasury’s cash infusions follow a complicated playbook. It immediately will take a $1 billion equity stake in each company that could grow to be as large as $100 billion each and which would be senior to both existing preferred and common shares.

The senior preferred stock obtained by the Treasury will carry warrants that will give the government an ownership stake of 79.9 percent and other benefits.

Treasury also set up a program under which it would buy mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac to pump fresh funds into the mortgage market through the end of next year.

The financing scheme does not eliminate existing common and preferred stock, but requires existing shareholders to absorb any losses ahead of the government. Over time, if Fannie and Freddie emerge from restructuring healthy and profitable again, stockholders may benefit.

Financial analysts applauded the move, but stock investors were expected to react badly to their much-diminished prospects when markets reopen Monday.

“The nationalization of Fannie and Freddie hits some right notes,” said Rob Cox, analyst at BreakingViews.com. “The CEOs are ousted, equity and preferred holders are hosed and the businesses run off. This should help stabilize U.S. housing. But it leaves the inevitable task of dismantling the [government sponsored enterprises] to a future administration.”

Dominique Strauss-Kahn, managing director of the International Monetary Fund, said the cash infusion was necessary, but should be followed up with an overhaul of the agencies next year. “The Treasury plan allows time to build widespread consensus for important reforms to these institutions, while ensuring, meanwhile, market stability and support for the economic recovery,” he said.

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