U.S. Government Takes Control of Ailing Mortgage Giants Fannie Mae and Freddie Mac

By Jennifer Yousfi
Managing Editor

In what could prove to be the biggest federal bailout in U.S. history, the federal government will take control of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) - the U.S. government's latest attempt to blunt a credit crisis that has spawned more than $500 billion in losses since it began.

U.S. Treasury Secretary Henry Paulson and Federal Housing Finance Agency Director James Lockhart held a joint press conference yesterday (Sunday) to unveil and detail the plan to place the two government-sponsored entities (GSEs) under a federal conservatorship.

"We examined all options available, and determined that this comprehensive and complementary set of actions best meets our three objectives of market stability, mortgage availability and taxpayer protection." said Paulson, who further noted that "conservatorship was the only form in which I would commit taxpayer money to the GSEs," TheStreet.com reported.

The two lenders together secure almost half of the $12 trillion in home loans that make up the U.S. home mortgage market; indeed, the two firms have been the source of near-constant conjecture over the past several months as experts raised questions about their fiscal stability.

And with good reason: Over the past 12 months, Fannie and Freddie have racked up a combined $14 billion in losses and write-downs, sending their stocks plummeting down more than 82% and 85% respectively year-to-date.

After a probe led by Morgan Stanley (MS) auditors assigned by Paulson found that certain accounting methods - while technically legal - had allowed both Fannie and Freddie to overstate their current capital levels, the government stepped in.

Under the conservatorship plan, the U.S. Treasury Department will purchase up to $100 million in special preferred securities. Current shareholders won't be eliminated, but they will move to the back of the line for any future claims.

In an effort to cut costs, all Fannie and Freddie dividends will be eliminated, and all lobbying activities will be prohibited. In addition, both current chief executive officers will be replaced.

Herbert Allison, former chief executive of TIAA-CREF, will replace Daniel Mudd, Fannie's now-deposed CEO. Meanwhile, David Moffett, one-time vice-chairman of U.S. Bancorp (USB), will take over for Freddie Mac CEO Richard Syron.

Paulson and Lockhart were quick to reassure taxpayers that the new CEOs would receive smaller compensation packages than the departing Mudd and Syron.

"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," U.S. President George W. Bush said yesterday in a statement released by the White House, Bloomberg News reported.

"The actions taken today are temporary," Bush said. As the administration considers the companies' future role, ``it is critical that they not pose similar risks to our economy and to our financial system again.''

Reaction to the government's plan was mixed. While the importance of Fannie and Freddie to the mortgage industry is widely acknowledged, some feel government intervention is the wrong course to follow.

"Keeping them alive is the wrong approach," Peter Wallison, a fellow at the American Enterprise Institute in Washington and a former Treasury Department general counsel, told Bloomberg. "They need to be sustained, they're essential to financing housing right now. But it doesn't mean that they have to be maintained as GSEs."

But legendary income investor Bill Gross of Pacific Investment Management Co. LLC, better known as PIMCO, who had begged the government to intervene to counteract a "financial tsunami," was pleased with the news.

"We own lots of mortgage-backed bonds, and I would expect on Monday and in the ensuing weeks for them to do very well," Gross said in a Bloomberg Radio interview. "So yes, I'm smiling at the moment."

The government's temporary authority expires at the end of 2009, giving the new CEOs just a little over a year to right the foundering mortgage behemoths.

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