6 September 2008

U.S. Plans to Seize Fannie and Freddie

WASHINGTON — Senior officials from the Bush administration and the Federal Reserve on Friday informed top executives of Fannie Mae and Freddie Mac, the mortgage-finance giants, that the government is preparing a plan to seize the two companies and place them in a conservatorship, officials and company executives briefed on the discussions said.

The plan, effectively a government bailout, was outlined in separate meetings that the chief executives were summoned to attend on Friday at the office of the companies' new regulator. The executives were told that under the plan, they and their boards would be replaced, and their shareholders virtually wiped out, but that the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

It is not possible to calculate the cost of any government bailout, but the huge potential liabilities of the companies could cost taxpayers tens of billions of dollars and make any rescue among the largest in United States history.

The drastic effort follows the bailout earlier this year of Bear Stearns, the investment bank, as government officials continue to grapple with how to stem the credit crisis and housing crisis that have hobbled the economy. With Bear Stearns, the government provided guarantees and the bulk of its assets were transferred to J.P. Morgan Chase, leaving shareholders with a nominal amount.

Under a conservatorship, most if not all of the remaining value of the common and preferred shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers. A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets.

The officials said that the executives were told that the government had been planning to announce the decision as early as Sunday, before the Asian markets reopen.

For months, administration officials have grappled with the steady erosion of the books of the two mortgage finance giants. A fierce behind the scenes debate among policymakers has considered whether to seize the companies or let them work out their problems.

But the declining housing and financial markets have apparently now forced the administration's hand. With foreign governments growing increasingly skittish about holding billions of dollars in securities issued by the companies, no sign that their losses will abate any time soon, and the inability of the companies to raise new capital, the administration apparently decided it would be better to act now rather than closer to the presidential election in two months.

Just five weeks ago, President Bush signed a law to give the administration the authority to inject billions of dollars into the companies through investments or loans. In proposing the new legislation, Treasury Secretary Henry M. Paulson Jr. said that he had no plan to provide loans or investments, and that merely giving the government the authority to backstop the companies would provide a strong shot of confidence to the markets. But the thin capital reserves that have kept the two companies afloat have continued to erode as the housing market has steadily declined and the number of foreclosures has soared.

As their problems have deepened—and the marketplace has come to expect some sort of government rescue — both companies have found it difficult to raise new capital to absorb future losses. In recent weeks, Mr. Paulson has been reaching out to foreign governments that hold billions of dollars of Fannie and Freddie securities to reassure them that the United States stands behind the companies.

In issuing their quarterly financial statements last month, the two companies reported huge losses and predicted that home prices would fall more than previously projected.

The debt securities the companies issue to finance their operations are widely owned by foreign governments, pension funds, mutual funds and big companies.

Officials said the participants at the meetings included Mr. Paulson, Ben S. Bernanke, the chairman of the Federal Reserve, and James Lockhart, the head of both the old and new agency that regulates the companies. The companies were represented by Daniel H. Mudd, the chief executive of Fannie Mae, and Richard F. Syron, chief executive of Freddie Mac. Also participating was H. Rodgin Cohen, the chairman of the law firm Sullivan & Cromwell, who was representing Freddie.

Officials and executives briefed on the meetings said that Mr. Mudd and Mr. Syron were told that they would have to leave the companies.

Representatives of the two companies did not return telephone calls seeking comment.

The meetings reflected the reality that senior administration officials did not believe they had the luxury of waiting for some kind of financial tipping point, as happened with Bear Stearns, which was saved from insolvency last March by government intervention after its stock plummeted and lenders withheld their capital.

Instead, Mr. Paulson has struggled to navigate through three potentially conflicting goals—stabilizing the financial markets, making mortgages more widely available in a tightening credit environment, and protecting taxpayers from possibly enormous losses.

Publicly, administration officials have tried to bolster the companies because the nation's mortgage system relies on their continued ability to purchase mortgages from commercial lenders and pull the housing markets out of their slump.

But privately, senior officials have been critical of top executives at the companies, particularly Freddie Mac. They have raised concerns about major risks to taxpayers of a bailout of companies whose executives have received huge compensation packages. Mr. Syron, for instance, collected more than $38 million in compensation since he joined the company in 2003.

Although Mr. Syron promised regulators earlier this year that he would raise $5.5 billion from investors, he has repeatedly failed to make good on that promise — even as Fannie Mae raised more than $7 billion. Mr. Syron was slated to step down from the chief executive position last year, but that was delayed when his appointed successor, Eugene McQuade, chose to leave the company.

Freddie Mac has approached numerous people about the chief executive position, including Kenneth I. Chenault of American Express and Laurence D. Fink of BlackRock, both of whom said they did not want to be considered for the position.

Another contender has been David Vitale, a former banking executive, a former chief executive of the Chicago Board of Trade, and adviser to the Chicago public school superintendent. Mr. Vitale declined to comment on whether he had been offered or accepted a position at Freddie Mac.

With the possible removal of the top management and the board, it is no longer clear who would appoint the new management.

Mr. Paulson had hoped that merely having the authority to bail out the two companies, which Congress provided in its recent housing bill, would be enough to calm the markets, but if anything anxiety has been increasing. The clearest measure of that anxiety has been the gradually widening spread between interest rates on Fannie- or Freddie-backed mortgage securities and rates for Treasury securities, making home mortgages more expensive. The stock price of the companies has also plunged over the last year.

After stock markets closed on Friday, the shares of Fannie and Freddie plummeted. Fannie was trading around $5.50, down from $70 a year ago. Freddie was trading at about $4, down from about $65 a year ago.

With Fannie and Freddie guaranteeing about $5 trillion in mortgage-backed securities, and a big share of those securities held by central banks and investors around the world, Mr. Paulson appears to have decided that the stakes are too high to take any chances.

One challenge for Mr. Paulson is that the Treasury Department is required by the new law to obtain agreement from the boards of Fannie and Freddie on any kind of capital infusion, which means Mr. Paulson has to negotiate to some degree with the two mortgage companies.

The exception to that requirement is if the companies' regulator, Mr. Lockhart, determines that the companies are insolvent or deeply undercapitalized. In that event, the government would have the authority to change the companies' managements and go so far as to take the companies over.

Experts said that the longer the administration waited, the greater the potential risks and costs.

Charles Calomiris, a professor of economics at Columbia University's School of Business, said delaying a government rescue would only increase the risks and costs.

“The last thing you want to do is give a distressed borrower more time, because when people are in distress they tend to take a lot of risks,” Mr. Calomiris said. “You don't want zombie institutions floating around with time on their hands.”

Stephen Labaton reported from Washington and Andrew Ross Sorkin from New York. Edmund L. Andrews contributed reporting from Washington, and Eric Dash and Charles Duhigg from New York.

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