Paulson to Take Over and Restructure Fannie, Freddie (Update4)

By Dawn Kopecki and Alison Vekshin

Sept. 6 (Bloomberg) -- Treasury Secretary Henry Paulson will use his authority to rescue Fannie Mae and Freddie Mac, likely placing the beleaguered mortgage-finance companies under government control as early as this weekend.

The Treasury plans to put Fannie and Freddie into a so- called conservatorship and pump capital into the companies, House Financial Services Committee Chairman Barney Frank said in an interview after being briefed by Paulson. The government would make periodic injections of funds by buying convertible preferred shares or warrants in the companies as needed, avoiding large up- front taxpayer costs, according to a person briefed on the plan.

``This is no bailout, particularly for the shareholders,'' Frank said. The federal government ``will be senior to all shareholders, preferred and common.''

Paulson gathered with Federal Reserve Chairman Ben S. Bernanke, Federal Housing Finance Agency Director James Lockhart, Fannie Mae Chief Executive Officer Daniel Mudd and Freddie Mac CEO Richard Syron this weekend on a plan to take control of the government-sponsored enterprises, which have operated as private shareholder-owned corporations for almost 40 years. Paulson is seeking to halt the crisis of confidence in Fannie and Freddie following $14.9 billion in losses in the past year that boosted their borrowing costs and hampered the mortgage market.

Paulson was prompted to step in after Morgan Stanley, which had been hired to analyze the companies' financials, concluded that Freddie, and to a lesser extent Fannie, relied on accounting maneuvers to meet their capital requirements, according to people with knowledge of the findings. The accounting overstated the value of their actual reserves, the people said.

Mark Lake, a spokesman at Morgan Stanley in New York, declined to comment.

Morgan Stanley

A government takeover would be the latest attempt to blunt the impact of the yearlong credit crisis, after the Fed provided financing for Bear Stearns Cos.'s sale to JPMorgan Chase & Co.

Holders of Fannie and Freddie corporate debt and preferred shares are ``very unlikely to come out of this at all happy,'' and the chief executive officers will be forced out, Frank said. Paulson met with Fannie Mae CEO Daniel Mudd and Freddie Mac CEO Richard Syron yesterday to tell them of the decision to put the companies into conservatorship, and remove the executives from their jobs, according to two people briefed on the discussions.

Paulson consulted with Bank of America Chief Executive Officer Kenneth Lewis, according to people with knowledge of the talks. A public announcement is expected this weekend, one person said. Frank said he plans to hold a hearing next week.

Treasury Briefings

Treasury was ``convinced that the markets simply wouldn't respond until after something like this,'' Frank said in the interview. ``What they're talking about doing are two things, one is conservatorship and two, putting some money into them. I think it's an important combination.''

The Treasury briefed Democratic presidential candidate Barack Obama today and has contacted Republican contender John McCain's staff about its intentions. Officials have also discussed the plans with House Speaker Nancy Pelosi, Senate Majority Leader Harry Reid and Senate Banking Committee Chairman Christopher Dodd.

Obama and McCain gave their support for federal action to rescue Fannie and Freddie while saying steps must be taken to ensure the companies don't keep passing losses off to taxpayers.

``These entities are so big and they are so tied into the housing market that it's probably true that we have to take steps to make sure that they don't just collapse,'' Obama said today while campaigning in Terre Haute, Indiana.

Fannie was created by the government in 1938 and Freddie was chartered in 1970 mainly to boost the availability of home loans and provide market stability. The companies currently own or guarantee almost half of the $12 trillion in U.S. home loans.

Opening Their Wallets

The decision to rescue Fannie and Freddie follows Paulson's repeated comments to lawmakers in July that he wasn't likely to use taxpayer funds to prop up the companies. The shares of both companies have slid since Paulson won powers to inject unlimited funds in the companies, and their borrowing costs rose.

Pacific Investment Management Co., manager of the world's biggest bond fund, and other large investors may put in their own money once the Treasury decides to inject government funds, Bill Gross, co-chief investment officer at Newport Beach, California- based Pimco, said yesterday in a Bloomberg Television interview.

``They have to open their wallet,'' Gross said. About 61 percent of Gross's holdings were mortgage-backed securities as of June 30, mostly debt guaranteed by Fannie, Freddie or government agency Ginnie Mae, according to data on Pimco's Web site.

Making Progress

Washington-based Fannie and Freddie dropped in after-hours trading yesterday. Fannie fell $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70. Fannie is down about 66 percent since the end of June as concerns about the companies' capital grew. Freddie has fallen about 69 percent.

Fannie's market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie's has fallen to $3.3 billion, from $22 billion over the same period.

``We are making progress on our work with Morgan Stanley, FHFA and the Fed,'' Treasury spokeswoman Brookly Mclaughlin said yesterday in Washington, declining to comment on any specific plans. FHFA spokeswoman Stefanie Mullin declined to comment, as did Mark Lake at Morgan Stanley.

Bernanke participated in yesterday's meetings because the central bank was given a consultative role in overseeing Fannie's and Freddie's capital under legislation approved in July. Paulson's decision won the approval of Bernanke and Lockhart, the person briefed on the discussions said.

Shareholders' Fates

The FHFA has the authority to place Fannie or Freddie into conservatorships or receiverships under the law. The legislation that President George W. Bush signed July 30 also gave the Treasury the power through the end of next year to extend unlimited credit to or make equity purchases in the firms.

Under a conservatorship, the authorities would aim to preserve Fannie and Freddie assets, rather than dispose of them, the law says.

The FHFA was scheduled to release its assessment of the companies' capital levels as early as this week as part of a quarterly appraisal of their finances.

Analysts have speculated that the Treasury would wipe out common shareholders, while seeking to shield preferred stockowners from total loss. Fannie and Freddie preferred shares are typically owned by banks and insurance companies. Their $5.2 trillion of debt outstanding is held by investors including Asian central banks, and would probably be guaranteed, analysts said.

Expanding Ownership

Standard & Poor's and Moody's Investors Service cut the preferred stock ratings of both companies to the lowest investment-grade quality on concern a bailout may not extend to the securities. S&P reduced the rating to the lowest investment grade, citing ``uncertainty'' about whether any government bailout would extend to the securities. The senior debt, implicitly backed by the government, carries the top ratings.

``Treasury's main concern is the debt markets, and if it was to say that it will do whatever is necessary to keep Fannie and Freddie running, the better it is for their funding,'' said Alex Pollock, fellow at the American Enterprise Institute in Washington and former president of the Chicago Federal Home Loan Bank.

Fannie was created in 1938 as part of President Franklin D. Roosevelt's New Deal. With the Vietnam War pressuring the federal budget, Fannie was split from the government in 1968, and shares in the company were sold to the public. Freddie was created in 1970 to provide competition for Fannie. The companies make money by buying mortgages from banks, funding their purchases with low- cost debt, and by guaranteeing home-loan securities.

Record Spreads

The government has been leaning on the companies to help pull the economy out of a housing slump as other buyers retreat from the market, burned by more than $500 billion of losses since the collapse of the subprime-mortgage market last year.

Fannie and Freddie need to sell billions of dollars of bonds each month to pay maturing debt. As of mid-August the companies had $223 billion of debt to refinance by the end of the quarter.

While they have continued to issue securities, Fannie and Freddie have paid record yields over U.S. Treasuries to attract investors reluctant to take on the debt even with its implicit backing from the government.

Freddie sold $3 billion of two-year reference notes this week at 3.229 percent, or 97.5 basis points more than Treasuries of similar maturity, the highest since at least 1998, based on company and market data compiled by Bloomberg.

Fannie had $47 billion of capital as of June 30, according to company filings. The company is required by its regulator to hold $37.5 billion. Freddie's capital stood at $37.1 billion, compared with a requirement of $34.5 billion, filings show.

Mudd was accompanied in his meetings at FHFA yesterday by Fannie General Counsel Beth Wilkinson and Chairman Stephen Ashley. Last week, he shook up the company's management in an effort to restore investor confidence, replacing three top deputies.

To contact the reporter on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net; Alison Vekshin in Washington at avekshin@bloomberg.net;

Last Updated: September 6, 2008 19:24 EDT