September 7, 2008 / 11:08 PM / 11 years ago

Fannie, Freddie takeover a pre-emptive strike

WASHINGTON (Reuters) - The U.S. Treasury has been worrying and wrangling over Fannie Mae’s and Freddie Mac’s capital levels and systemic risks for years. So why move now to seize control of the two troubled mortgage finance giants?

Mounting credit losses, waning foreign appetite for the institutions’ mortgage-backed securities and a sobering review by Morgan Stanley prompted Treasury Secretary Henry Paulson to launch what may become the most costly bailout in U.S. history.

“Rather than waiting until a triggering event — but seeing one on the horizon — they decided to strike preemptively,” said Bert Ely, a longtime banking industry consultant in Alexandria, Virginia.

“They lined up the evidence to present this to the Fannie and Freddie boards before their hand was forced like it was with Bear Stearns,” he added.

At the crux of the matter is housing and the economy. With mortgage default rates rising, markets have been losing confidence in the viability of Fannie Mae and Freddie Mac, government-sponsored enterprises that buy mortgages from lenders and hold them or securitize and sell them on to investors.

As demand for their paper diminishes, the cost of mortgages rises, putting more pressure on the already battered housing market.

“He (Paulson) has got to fix housing. Fixing the GSEs is critical to fixing housing. He has to do it before he leaves office,” said Michael Youngblood, principal of Five Bridges Capital LLC in Bethesda, Maryland.

FOREIGN APPETITE WANES

Foreign investors, in particular, have been shunning Fannie and Freddie securities, long viewed as nearly as safe as Treasury debt due to an implied government backing. They cut their holdings of U.S. agency securities by $9.75 billion in the week ended September 3, marking the seventh weekly drop in a row, according to Federal Reserve data.

The Bank of China recently said it cut its holdings of Fannie and Freddie securities to $12.67 billion as of August 25 from the end of June, and Russia has reduced its holdings of Fannie, Freddie and Federal Home Loan Bank securities by around $40 billion this year by not replacing maturing paper. A central bank official said last week further reductions were being made.

“There is little doubt that foreign central bank holdings of agency bonds were a major factor shaping Treasury thinking on how to deal with the Fannie/Freddie restructuring. The People’s Bank of China, of course, is the largest foreign holder of agency paper,” said Nicholas Lardy, senior fellow with the Peterson Institute for International Economics in Washington.

Domestic investors, too, have voiced concern. Bill Gross, the influential chief investment officer of Pacific Investment Management Co called upon the Treasury last week to open its balance sheet to halt a “financial tsunami” of debt and asset liquidation.

MORGAN STANLEY INFLUENCE

A month of consultations with Morgan Stanley, hired as an adviser to the Treasury on August 5 on its recently minted GSE backstop authority, appeared to be influential in making up Paulson’s mind to grab the reins of Fannie and Freddie.

Senior government officials said the consultations with Morgan Stanley and the Federal Housing Finance Agency regulator revealed the GSEs capital base was inadequate for the mortgage losses they faced and their ability to raise new equity capital was impaired by the massive drop in their share prices in recent months.

“Based on what we have learned about these institutions over the last four weeks — including what we learned about their capital requirements — and given the condition of financial markets today, I concluded that it would not have been in the best interest of taxpayers for Treasury to simply make an equity investment in these enterprises in their current form,” Paulson said in a statement.

The Treasury has said there would not be a final report on Morgan Stanley’s conclusions about Fannie and Freddie.

Analysts also said the picture for Fannie and Freddie could worsen significantly with their third-quarter financial reports in coming weeks, which is likely to show increasing credit losses and delinquencies from subprime and near-prime “Alt-A” loans.

Also by the end of September, Fannie and Freddie are scheduled to roll over some $500 million in debt, which could go badly if markets lack confidence in the two institutions.

Although the move was bold and intricately structured to preserve equity and existing preferred shareholders while providing new capital on a quarterly basis as needed, some regarded the move as only a partial step, leaving a full takeover to the next president.

“They’re kind of doing this in dribs and drabs, putting in enough capital to get us through to next year. It strikes me as a bit half-hearted,” said Morris Goldstein, a senior fellow at the Peterson Institute.

Additional reporting by Burton Frierson and Richard Leong in New York; Editing by James Dalgleish

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