Many woes, not single failing, pushed GSE takeover

WASHINGTON (Reuters) - The U.S. Treasury decided to seize control of Fannie Mae and Freddie Mac after concluding that the companies could not sustain mounting mortgage losses and still offer critical aid to the broader housing markets, said sources familiar with the move.

The Treasury found no smoking gun to indict the companies and there was no single failing that prompted the takeover, the sources said.

Rather, Treasury Secretary Henry Paulson's outlook darkened over weeks of internal debate, briefings from outside consultants and meetings with the government-sponsored enterprises' (GSE) main regulator.

Specifically, Paulson worried that Fannie Mae and Freddie Mac did not have enough capital to withstand mounting credit losses and that Wall Street would continue to shun their stock, making it impossible to raise new equity capital.

Without investor cash, Fannie Mae and Freddie Mac would have to raise the costs of their mortgages and shrink their balance sheets just as policy-makers were relying on the companies to keep home buying costs low.

RESPONSIBILITY WITHOUT POWER

While Paulson and a handful of other officials formed the government's brain trust on GSE policy, the Treasury lacked the authority to seize Fannie Mae and Freddie Mac in an orderly way.

The Treasury could take an equity stake in either company under a rescue plan conceived by Paulson in July, but only after executives agreed to such a move.

Only the Federal Housing Finance Agency, the companies' main regulator, had broad power to take Fannie Mae and Freddie Mac into government hands if the companies were found to be nearing collapse -- authorization granted by Congress just weeks ago in a sweeping housing rescue bill.

James Lockhart, the director of the FHFA and its predecessor agency, said in July that Fannie Mae and Freddie Mac capital fears were overstated and in early August he was writing fresh capital standards that would serve the companies for years to come.

Through most of August, Lockhart and Paulson led shuttle meetings and brainstorming sessions with executives from the GSEs about how to get through the financial thicket.

An industry source with knowledge of the meetings describe them as frank, cordial and businesslike.

"They wanted us to help brainstorm and develop ideas. We were painfully honest about different scenarios," the source said.

But while Fannie Mae and Freddie Mac executives were expecting a government lifeline, the Treasury was mulling more drastic action.

STRONG MEDICINE

By late August, some analysts thought that the worst of the crisis was beginning to pass for Fannie Mae and Freddie Mac.

The companies' borrowing costs were still relatively low, and while Fannie Mae and Freddie Mac suffered a combined $14 billion in losses over the past four quarters, they still had more than $80 billion in capital on hand.

Still, investment bankers on loan from Morgan Stanley took a fresh look at the companies' capital position and warned the Treasury that it was dangerously thin. Investment banks, too, were shutting their doors to Fannie Mae and Freddie Mac and Foreign investors, who had largely bankrolled the U.S. housing boom earlier this decade, were shying away from their debt and mortgage-backed securities.

In recent days, Treasury officials persuaded Lockhart that he should assert his right to take over the two companies based on capital seen as inadequate for expected losses and inability to raise new capital in private markets.

In separate letters from the regulator to Fannie Mae and Freddie Mac, the FHFA recited the companies' failings and officially raised the possibility of taking control.

"It was about 15 pages long and buried in there were three or four lines that practically recited the language on receivership," said one industry source who has seen the letter.

Lockhart's authority to make the move now largely hinged on one word: likely.

The regulator could take control if he determined that either Fannie Mae or Freddie Mac were "likely to be unable to pay its obligations" or was "likely to incur losses that will deplete all or substantially all of its capital," according to language in the new housing law.

On Friday, executives from Fannie Mae and Freddie Mac were summoned by Lockhart for face-to-face meetings with Paulson and Federal Reserve Chairman Ben Bernanke.

Lockhart recited key elements of the letter to the chief executive officers of both companies: Fannie's Daniel Mudd and Freddie's Richard Syron.

The policy-makers were blunt when one of the CEOs asked how they would justify taking such drastic action, said a source familiar with the exchange.

"The basic answer to 'Why are you doing this?' was 'Because we can,'" the source said.