WASHINGTON — Capping months of speculation over the health and viability of Fannie Mae and Freddie Mac, the government took control of both government-sponsored enterprises Sunday in an effort to soothe the housing and financial sectors.
The Federal Housing Finance Agency seized Fannie and Freddie after government officials determined the GSEs did not have sufficient capital to survive the losses they are expected to post in the quarters ahead. Since the beginning of 2007, both companies have lost a combined $10.6 billion.
The move also coincided with speculation that accounting irregularities had been uncovered at Freddie.
"I have determined that the companies cannot continue to operate safely and soundly and fulfill their critical public mission," FHFA Director James Lockhart said. "Therefore, in order to restore the balance between safety and soundness and mission, FHFA has placed Fannie Mae and Freddie Mac into conservatorship."
Treasury Secretary Henry Paulson did not blame management or regulators for the failings of the GSEs. Instead, he said their public-private model was fundamentally flawed, and said Congress must revamp it during the next year.
"There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form," Mr. Paulson said at a morning press conference. "Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes."
But Mr. Paulson declined to make recommendations on what he would do, saying only that he would offer his opinion in the weeks ahead. He emphasized that the steps taken Sunday were intended to be temporary and to give Congress and the next administration time to determine the future of the enterprises.
"I recognize that there are strong differences of opinion over the role of government in supporting housing, but under any course policymakers choose, there are ways to structure these entities in order to address market stability in the transition and limit systemic risk and conflict of purposes for the long-term," he said. "We will make a grave error if we don't use this time out to permanently address the structural issues presented by the GSEs."
With the government now in charge, Mr. Paulson announced three separate plans to shore up Fannie and Freddie and allow them to access liquidity as needed. First, the Treasury will make an initial purchase this month of $5 billion of mortgage-backed securities guaranteed by Fannie and Freddie. The MBS market has dried up in recent months, effectively driving up the cost of mortgages.
Independent asset managers will purchase and oversee the transactions for Treasury. Purchases beyond the initial $5 billion will be made "as deemed appropriate," according to a fact sheet provided by the Treasury.
Second, the Treasury created a new liquidity tool to lend directly to Fannie and Freddie if needed.
"This facility is intended to serve as an ultimate liquidity backstop," Mr. Paulson said.
The funds for any loans through this facility will come from the Treasury's account at the Federal Reserve Bank of New York. Senior government officials compared the facility to the primary dealer credit facility the government established in March to provide liquidity to investment banks.
The loans are expected to be short-term, with maturities generally of a week to a month, and will carry rates of 50 basis points above the London Interbank Offered Rate.
The Federal Home Loan Banks will also be able to tap the new facility though Mr. Lockhart said the system is strong and will not likely need the liquidity.
Finally, the government became a senior preferred shareholder at Fannie and Freddie. The agreement allows the government to tap up to $100 billion in equity. It will take an initial $1 billion stake soon.
The Treasury insisted it took steps to avoid taxpayer risk. The government will receive quarterly dividend payments that work out to 10% per year. If a GSE does not pay dividends in cash, it must pay the government at 12%.
The agreement also gives the Treasury an ownership stake of 79.9% in Fannie and Freddie and quarterly fees beginning in 2010.
If liabilities at a GSE ever exceed assets under generally accepted accounting principles, the Treasury agreed to hand that GSE cash to make up the difference. For instance, if the government discovered a $500 million gap between assets and liabilities, it would provide $500 million in cash to the GSE.
The Treasury would then tack that amount on to its equity holdings. If the Treasury already held a $1 billion stake in a GSE and needed to provide $500 million to close a gap, the new equity stake would be $1.5 billion, for example.
"These agreements support market stability by providing additional security and clarity to GSE debt holders - senior and subordinated - and support mortgage availability by providing additional confidence to investors in GSE mortgage-backed securities," Mr. Paulson said.
For the most part, debt and equity holders remain whole. Fannie and Freddie will pay interest on senior and subordinated debt according to existing agreements.
Common shareholders will lose their voting rights while the GSEs are under conservatorship but will not see their equity holdings vanish. Preferred shareholders, many of whom are banks and foreign government, remain whole.
Still, Mr. Paulson emphasized that investors will not emerge unscathed.
"While conservatorship does not eliminate common stock, it does place common shareholders last in terms of claims on the assets of the enterprise," he said. "Similarly, the conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses."
Moreover, neither class of shareholders will receive dividends and, in the event of losses, their claims are subordinated to the government. Mr. Lockhart said the dividend suspension would conserve over $2 billion in capital each year.
Mr. Paulson urged Wall Street not to draw broader conclusions about the financial sector from the problems at Fannie and Freddie.
"Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly," he said. "By stabilizing the GSEs so they can better perform their mission, today's action should accelerate stabilization in the housing market, ultimately benefiting financial institutions."
Even though shareholders will not receive dividend payments, the industry will likely breathe a sigh of relief that they were not wiped out. The industry's exposure to preferred stock and subordinated debt at Fannie and Freddie has become a crucial concern at Fannie and Freddie in recent weeks. Had the Treasury wiped out these classes, an important source of capital would have been eliminated from bank balance sheets at a time when capital is hard to come by.
The banking regulators issued a joint statement Sunday morning saying the agencies have been studying the industry's exposure to Fannie and Freddie's preferred shares.
"The agencies believe that, while many institutions hold common or preferred shares of these two government-sponsored enterprises, a limited number of smaller institutions have holdings that are significant compared to their capital," according to the press release. "The Federal Reserve Board, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, and the Office of Thrift Supervision are prepared to work with these institutions to develop capital-restoration plans pursuant to the capital regulations and the prompt corrective action provisions of the Federal Deposit Insurance Corp. Act."
The actions on Sunday translate into major changes at Fannie and Freddie. For starters, the chief executives of both companies are out. Herb Allison, the former president of Merrill Lynch, will take the reins of Fannie while David Moffett, the former vice chairman and chief financial officer of US Bancorp, will lead Freddie.
Compensation, which has long been a lightening rod issue on Capitol Hill, will be "significantly lower than the outgoing CEOs," Mr. Lockhart said.
The former CEOs, Dan Mudd of Fannie and Richard Syron of Freddie, will remain in place for a brief transition period and it is unclear how they will be compensated for their forced departures.
Meanwhile, the FHFA will grow the enterprises' mortgage portfolios. In the wake of second quarter losses, both Fannie and Freddie said they would be more conservative in their mortgage purchases. Under a conservatorship, however, they might now boost their holdings to $850 billion each. The portfolios at both companies currently rest just below $800 billion.
By 2010, the portfolios are expected to begin shrinking again, Mr. Paulson said. He estimated they will drop at a rate of 10% a year. Senior government officials said Sunday the portfolios may - over the course of 10 years - eventually fall to as little as $250 billion each.
Mr. Lockhart also said "all political activities, including lobbying" will end at the GSEs. In their heyday during the housing boom, Fannie and Freddie became lobbying giants on Capitol Hill.
The announcements are sure to fuel more political debate over the virtue of government bailouts. Sens. John McCain and Barack Obama, the Republican and Democratic presidential candidates were briefed by Mr. Paulson on the rescue package. Sen. Obama said Sunday he supported helping Fannie and Freddie, but would closely examine the details of Treasury's plan.
There will also likely be further probing into the GSEs' accounting methods. Freddie, in particular, is said to have structured its balance sheet in such a way to indicate it had more capital on hand than it really did.
Irregularities would be particularly troublesome since Fannie and Freddie already suffered through accounting scandals nearly five years ago. Restatements totaled $5 billion at Freddie in 2003 and $6.3 billion at Fannie in 2004.
Ironically, GSE legislation enacted in July was meant to correct the deficiencies that led to the enterprises' problems. The bill also included emergency powers that allowed the Treasury to temporarily make unlimited investments in Fannie's and Freddie's debt and equity.