U.S. talks with Fannie, Freddie turned sour: sources

WASHINGTON (Reuters) - Amicable talks between Fannie Mae and Freddie Mac and the U.S. mortgage finance companies' regulator about an aid package ended abruptly as policy-makers resolved in recent days to seize the firms, industry sources with knowledge of the events said.

The government on Sunday took control of the companies, the two largest sources of U.S. home finance, citing concern that mounting mortgage losses at the government-sponsored firms were leaving them unable to fulfill their mission of supporting the housing market in a safe and sound manner.

"A failure of either of them would cause great turmoil in our financial markets here at home and around the globe," U.S. Treasury Secretary Henry Paulson said in explaining the rationale for the extraordinary government action.

For the past four weeks, Treasury Department officials and executives from Fannie Mae and Freddie Mac had been discussing threats to the firms and how they might navigate their way through the devastating housing downturn while remaining intact.

The industry sources said the talks had been held in a collegial atmosphere but turned adversarial early last week when the companies' regulator sent them a letter enumerating failings that it argued were grounds for their seizure.

"The letter listed almost everything that had been a concern or under examination since" the companies had to restate earnings after accounting scandals, said one industry source familiar with the letter and the negotiations with the Treasury and the regulator, the Federal Housing Finance Agency (FHFA). "It was basically a grab-bag."

Fannie Mae and Freddie Mac were ordered to hold billions of dollars in capital more than normally required and have had to submit to tougher oversight after their flawed bookkeeping came to light several years ago.

CORDIAL DEALINGS DASHED

Executives at both companies were stunned by the tone of the letter, which ran to more than a dozen pages, and in which the regulator stressed for the first time that the companies could be taken over.

Paulson had hatched a plan in early July to backstop the struggling firms with a promise of fresh loans and a government injection of capital if either company was pushed to the brink of collapse.

At the time, Paulson said he did not expect to ever need to use this authority. Simply having the option, he contended, would be enough to settle nervous investors.

In pitching his plan, Paulson echoed the words of President George W. Bush and some lawmakers who said the companies should remain in private hands.

In the ensuing weeks, however, Wall Street fretted about who would be hurt by a possible government bailout and pressed for details of the steps Treasury might take if it felt the need.

Fannie Mae and Freddie Mac believed they could navigate the housing market downturn with the Treasury's assistance and were prepared to concede to management changes and a dilution of their shares, if required.

In late August, Fannie Mae sacked several executives and shuffled other roles in an attempt to right itself. Executives felt that such bloodletting would restore confidence in the companies and please regulators.

However, last week's letter dashed the spirit of comity that had existed during the talks, the sources said.

SUDDEN MEETING

On Friday afternoon, the chief executives of the two companies were summoned to separate meetings at the offices of FHFA Director James Lockhart. Paulson and Federal Reserve Chairman Ben Bernanke also attended.

In the prior weeks, Fannie Mae and Freddie Mac had worked with government officials to examine possible scenarios that could endanger the companies and generally laid themselves bare to regulators, sources with knowledge of the talks said.

At the opening of the meetings, the sources said, Lockhart recited key parts of the letters his agency had sent out and used the companies' stated vulnerabilities to justify taking the companies into conservatorship, under which the normal powers of the companies' directors and officers would be held by their regulator.

The companies were frustrated that, after weeks of good faith negotiations, they were given just 24 hours to decide whether they would accept conservatorship voluntarily or have it forced upon them.

"We were given an ultimatum -- do you want to die slowly or do you want to die quickly?" one source said.

(Editing by Neil Fullick)