US takes giant step into housing

September 8, 2008
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, WASHINGTON, September  8 – In rescuing Fannie Mae and Freddie Mac, the US government is taking an unprecedented step into the financial sector in a bid to steady an ailing housing market and ease a global credit crunch, analysts said.

A series of steps announced places the struggling mortgage finance giants in a "conservatorship," which is the equivalent of a bankruptcy reorganization under the aegis of the government.

In what is likely the largest US government intervention in the private sector, the plan effectively adds some 5.4 trillion dollars in potential liabilities from the two firms to the Treasury — equivalent to the entire federal debt.

The hope is that by opening up the vast coffers of the US government to the government-sponsored enterprises (GSEs), confidence will return to the housing and financial system, minimizing any losses.

"There is no quick fix. This is not one," said Robert Brusca at FAO Economics.
"But it should help to stabilize markets and give the government the opportunity to use the GSEs to help extract us from this mess."

Fannie Mae was originally a government agency created during Great Depression to help provide liquidity for housing. It was privatized in 1968 and Freddie Mac was chartered by Congress in 1970 to provide competition.

But many officials and analysts argue there was a contradiction in the mission of the two, which tried to maximize results for shareholders at the same time seeking to lower the cost of mortgage credit.

"I attribute the need for today\’s action primarily to the inherent conflict and flawed business model embedded in the GSE structure," Treasury Secretary Henry Paulson said in announcing the unprecedented takeover.

"Because the GSEs are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking."

Brusca said that "the real problem was their mission, their organizational form as GSEs and their size. The mortgage mess was just an inconvenient truth that made it all less viable and exposed the warts that had been there all along."

The takeover provides the US government with one billion dollars in a new class of preferred shares at no cost to taxpayers.

The new plan does not eliminate the existing common and preferred shares, but means they would absorb any losses ahead of the government, Paulson said.

Another step — authorized by emergency legislation passed by Congress in July — opens up a new, unspecified, Treasury line of credit to the two firms through the Federal Reserve.

Paulson also said Treasury "is initiating a temporary program" to purchase mortgage-backed securities of Fannie and Freddie, to help provide liquidity in a financial market strained by a credit crunch.

David Kotok, chief investment officer at Cumberland Advisors, said the new initiative "draws the line on moral hazard so the existing preferred and common shares do not get bailed out by the government."

The existing shares "most likely are worth a few pennies" but the fate will not be known for some years until the crisis is over, Kotok said.

Kotok said the plan will likely "jump start" the ability of Fannie and Freddie to pump money into the housing market and that "this will bring down mortgage rates."

Not all analysts welcomed the plan. Nouriel Roubini, a New York University economist who has been sounding the alarm for over a year on the financial crisis, said the plan is flawed.

"This bailout plan has mostly lousy features that exacerbate the moral hazard of this government intervention and the overall fiscal costs of such intervention," he said.

Peter Cohan, a management consultant at Peter Cohan & Associates, said the news may unsettle markets further.

"It will probably wipe out common equity holders and damage the worth of preferred shareholders," he said. "Despite the weeks of buildup to this plan, the bad news is now much clearer to investors than the good news."

Regardless, some said there was no choice but to save the companies that underpin trillions of dollars in mortgages to avert a wave of failures that would lead to a financial system meltdown.

"Our economy and our markets will not recover until the bulk of this housing correction is behind us," said Paulson.

"Fannie Mae and Freddie Mac are critical to turning the corner on housing.
Therefore, the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance."

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