Sunday, September 7, 2008

Inside The Big Bailout

Forbes.com

Liz Moyer, Brian Wingfield and Maurna Desmond 09.07.08, 2:18 PM ET

The situation at Fannie Mae and Freddie Mac deteriorated to such an extent over the summer that the Treasury Department's authority to inject capital into them would not be not enough. A full takeover was the only solution.

That was the conclusion Treasury reached last week after a month-long analysis of the mortgage finance giants.

"Based on what we have learned about these institutions over the last four weeks--including what we learned about their capital requirements--and given the condition of financial markets today, I concluded that it would not have been in the best interest of the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form," Treasury Secretary Henry Paulson said Sunday, announcing the massive four-pronged government rescue designed to save the $12 trillion housing market from further pain.

Markets had lost confidence in the mortgage finance giants after they accumulated losses of $14 billion over the last year. Their stock values have plummeted more than 90%, and foreign banks, which are major holders of Fannie and Freddie bonds, have been selling their holdings. The takeover puts taxpayers on the hook for potential 10s of billions in losses from the two firms' deteriorating portfolios of mortgage securities, $5 billion of which Treasury is set to buy later this month.

The announcement, while expected since Friday, still comes as a shock to some. "Overall its surprising that it came down to this, said Guy Cecala, an industry veteran and publisher of Inside Mortgage Finance. "Even though the conservativeship was built into the original legislation, it was a doomsday scenario. I guess in terms of the market, we are there."

Despite reports Sunday that the two firms, particularly Freddie, had overstated their capital resources, senior administration officials--speaking on background--told reporters at a briefing that government officials have not been provided evidence of any accounting wrongdoing by the companies. One official said a "confluence of a number of factors" was responsible for the government's emergency action. These include their current capital positions, their earnings prospects and limitations on their ability to tap capital markets. Officials dodged questions as to whether fear of a dollar run or concern by foreign central banks prompted the government's action, with one official saying Paulson was "mindful of all conditions."

Uncle Sam has come to the rescue of the financial markets twice in the last year as it scrambles to react to the credit crisis. In March, the Federal Reserve and other regulators intervened to halt the collapse of Bear Stearns, arranging for its sale to JPMorgan Chase to avert a cataclysmic chain reaction in the credit default swap markets. Ditto Fannie and Freddie, which control half the outstanding mortgage debt. "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," Paulson said. "A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance."

Paulson's rescue comes five weeks after Congress granted Treasury the authority to take extraordinary measures to shore up the companies, including $25 billion to buy Fannie and Freddie stock if the case arose. The government hired Morgan Stanley to help comb over the firms' books. Paulson has said in the last few weeks he wanted to avoid a government bailout, calling his new authorities the "bazooka" that would ward off intervention. What they found changed his mind.

James Lockhart, the head of the Federal Housing Finance Agency, said the companies have made progress in recent years on their accounting and risk management controls, but that conditions, including rising foreclosures and defaults, had "overwhelmed" the process. "Unfortunately, as house prices, earnings and capital have continued to deteriorate, their ability to fulfill their mission has deteriorated," Lockhart said. "In particular, the capacity of their capital to absorb future losses while supporting new business activity is in doubt."

Fannie and Freddie have long been the target of critics who say they use accounting tactics that make them appear healthier than they really are. One of the chief criticisms is that the two have not marked down the value of mortgage securities, intending to hold to maturity. Other financial companies have taken big cuts in their holdings using "mark to market" accounting regardless of whether they intend to sell in the near term.

Under previous management Fannie and Freddie have been accused of accounting shenanigans. Freddie paid fines of $125 million in 2003 to settle accusations it managed earnings and overstated profits by $5 billion over a three-year period from 2000 to 2003. A more stunning scandal hit Fannie a few years later. In 2006, the firm paid $400 million in fines--one of the largest accounting-related settlements on record--to settle accusations it misstated earnings by $10.6 billion from 1998 to 2004, all to help top executives achieve bonus and other compensation targets.

Fannie and Freddie are critical cogs in the U.S. housing market, owning or guaranteeing almost half of of outstanding home mortgage debt. Since the credit crisis, they have taken on an even bigger role, backing 70% of mortgages written as banks push loans off their balance sheets. Treasury is buying preferred shares in the two firms and taking them over through a conservatorship overseen by the Federal Housing Finance Agency, a new regulator created by Congress this summer as part of a sweeping effort to rescue the faltering housing market. TIAA-Cref's Herb Allison will take over from Daniel Mudd as Fannie's chief executive, and US Bancorp's David Moffett will take over from Richard Syron at Freddie. Treasury also will buy mortgage backed securities from the firms in the open market and provide a lending facility through its account at the Federal Reserve Bank of New York.

Officials spent much of their time Sunday briefing reporters on the details of the conservatorship and the Treasury Department's plans moving forward. First, later this month, Treasury will buy mortgage-backed securities from Fannie and Freddie in order to give them greater access to mortgage funding. These securities, expected to be worth about $5 billion total, will be managed by as yet unnamed third-party investment managers. This purchase program expires at the end of 2009, but the MBS can be held beyond that date. Critics say the companies need to sell off their portfolios of retained mortgage holdings and reduce their balance sheets. Treasury's plan calls for the reduction of their mortgage backed securities portfolios starting in 2010, at a 10% annual clip.

Treasury also has a preferred stock purchase agreement with Fannie and Freddie, valued at $100 billion each. That large number was chosen purely to provide a market signal that the government stands by its commitment to the mortgage buyers, officials said.

The government is making available a lending facility, though it does not expect to have to use this option.

Monday morning, stockholders of Fannie and Freddie will wonder whether their stock has any value. The government it going out of its way to preserve common stock, but undoubtedly the value of those securities will fall. A senior administration official could not provide information on the government's position on what will happen to stockholders. "I don't think it's appropriate for me to speculate on," he said.

It is the bond holders and home buyers who are the government's chief concern. Borrowing costs for Fannie and Freddie have ballooned compared to the rate on Treasurys, an indication of the growing concern over the companies. With the full explicit backing of the Treasury, those borrowing costs will drop, and that will ultimately make home loans more affordable. Under conservatorship, Fannie and Freddie will continue to operate as a buyer and packager of mortgage securities, which is critical to supporting the housing market.

Regulators are walking a tightrope to avoid spooking the markets and setting off another avalanche. The timing of the announcement Sunday comes before the opening of Asian markets. In March, the announcement of a rescue of Bear Stearns was handled in a similar fashion.

"These two institutions are unique," Paulson said. "They operate solely in the mortgage market and are therefore more exposed than other financial institutions to the housing correction. Their statutory capital requirements are thin and poorly defined as compared to other institutions. Nothing about our actions today in any way reflects a changed view of the housing correction or of the strength of other U.S. financial institutions."

The Federal Reserve also weighed in. "These necessary steps will help to strengthen the U.S. housing market and promote stability in our financial markets," Fed Chairman Ben Bernanke said in a statement. "I also welcome the introduction of the Treasury's new purchase facility for mortgage-backed securities, which will provide critical support for mortgage markets in this period of unusual credit-market uncertainty."

Foreign central banks and other financial institutions are major holders of Fannie and Freddie bonds, a fact that cannot have been lost on U.S. regulators, who are said to have been reassuring foreign bankers about the stability of their holdings. Fannie and Freddie debt and mortgage securities "are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free," Lockhart said. "We have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings."

Following the announcement Sunday morning, Standard & Poor's affirmed Fannie and Freddie long-term bond ratings at triple-A.

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