The U.S. government announced yesterday that it was taking control of mortgage giants Fannie Mae and Freddie Mac, saying the companies' weakened finances had made it impossible for them to carry out their missions of supporting the struggling housing market.
At a news conference in Washington, Treasury Secretary Henry M. Paulson Jr. laid out a plan to place the companies into conservatorship, under which the government will direct their operations from now on. The Treasury will make capital injections into the companies, up to $100 billion each over time, and lend them money as needed.
In a bid to bring down mortgage rates, the Treasury also will step in to buy some of the mortgage-backed bonds of the companies in the marketplace - in effect, taking home loans onto its own books.
Current investors in the companies won't have their shares canceled, but the value of the stocks could easily be wiped out, depending on how much taxpayer money it takes to stabilize the companies.
"I have long said that the housing correction poses the biggest risk to our economy," Paulson said. "It is a drag on our economic growth and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us. Fannie Mae and Freddie Mac are critical to turning the corner on housing."
President Bush backed Paulson in a statement issued by the White House:
"Americans should be confident that the actions taken today will strengthen our ability to weather the housing correction and are critical to returning the economy to stronger sustained growth."
The decision to take over the companies is the latest move by the government in its year-old struggle to respond to what many say is the worst financial crisis since the Great Depression.
Plummeting home prices and soaring mortgage defaults have ravaged the finances of Fannie Mae and Freddie Mac, which were created by the government decades ago to support the housing and mortgage markets by buying home loans from banks and thrifts.
Although they were chartered by the government, the companies are owned by investors, making for a strange hybrid that critics have long warned was fraught with peril.
Unfettered for years as they sought to boost earnings for their shareholders, the companies ballooned in size. Between them, Fannie Mae and Freddie Mac own or guarantee $5.4 trillion of U.S. home mortgages, about half the total outstanding.
With mortgage defaults rocketing, the companies' size has become a huge liability.
Nationwide, the portion of home loans at some stage in the foreclosure process was 2.75 percent at the end of June, up from 2.47 percent in the first quarter and 1.4 percent in the second quarter of 2007. The latest figure is the highest since the Mortgage Bankers Association began keeping track 29 years ago.
Fannie Mae and Freddie Mac have suffered about $14 billion in loan losses during the past year and could face a rising tide of red ink as the housing crisis wears on. Yet they have become more critical to the mortgage market as the U.S. credit crunch has worsened, and many lenders have been unwilling to make any home loans unless they can sell them to Fannie Mae or Freddie Mac.
As the companies' financial outlooks worsened in July, Congress gave the Treasury the authority to put taxpayer money into the companies to keep them solvent. The Federal Housing Finance Agency was also created this summer to regulate Fannie and Freddie; that agency will run the conservatorship.
"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. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today."
As expected, Paulson said the current chief executives of the companies would step down.
Fannie Chief Executive Daniel Mudd will be replaced by Herbert Allison, former chief of teachers pension fund TIAA-CREF; Freddie Chief Executive Richard Syron will be replaced by David Moffett, a former top executive of Minneapolis-based US Bancorp who now is an executive of the Carlyle Group, a Washington-based investment firm.
By placing the companies into conservatorship - which allows their shareholders to retain a slim hope of getting some of their money back - Paulson's plan is "a half-measure between doing nothing and a full nationalization," said Christopher Whalen, a partner at Hawthorne, Calif.-based research firm Institutional Risk Analytics.
Still, he said, the government's now-explicit backstopping of the companies' massive debts should allow Fannie Mae and Freddie Mac to pay lower rates to borrow, which in turn could allow them to reduce the rates they require on mortgages they buy from lenders.
Paulson said it would be up to the next Congress and president to decide "what role government in general, and these entities in particular, should play in the housing market.
Democratic presidential nominee Barack Obama issued a statement agreeing that some form of intervention was necessary, and promised, "I will be reviewing the details of the Treasury plan and monitoring its impact to determine whether it achieves the key benchmarks I believe are necessary to address this crisis."
Republican presidential nominee John McCain also voiced support while his running mate, Alaska Gov. Sarah Palin, said that Fannie and Freddie "have gotten too big and too expensive to the taxpayers. The McCain-Palin administration will make them smaller and smarter and more effective for homeowners who need help."
For years, critics of Fannie Mae and Freddie Mac have said that, although the companies' shareholders reaped the benefits of their home-loan investments in good times, it would inevitably fall to the government to cover their losses in a crisis. That warning now has come true.
The Associated Press contributed to this article.
THE TAKEOVER: The government is taking control of mortgage finance companies Fannie Mae and Freddie Mac, injecting money into them and installing new chief executives.
The government may buy up to $100 billion of preferred stock in each company, making the investments when needed. It also plans to make an initial purchase of $5 billion in mortgage-backed securities and will receive warrants representing ownership stakes of nearly 80 percent of each company.
THE REASON: Treasury Secretary Henry M. Paulson Jr. says the action is needed to stabilize the housing market and prevent the financial system from being thrown into chaos if either company collapses. That's critical because Fannie and Freddie own or guarantee about $5 trillion in mortgage loans.
THE COST: It will largely depend on how far home prices fall and how many more borrowers wind up defaulting. The Congressional Budget Office estimated earlier this year that such an intervention could cost about $25 billion but conceded that its projections were hazy.