Reuters and The Associated Press

September 7, 2008 at 1:24 PM EDT

WASHINGTON — The U.S. government on Sunday seized control of mortgage finance companies Fannie Mae and Freddie Mac , launching what could be its biggest federal bailout ever, in a bid to support the U.S. housing market and ward off more global financial market turbulence.

Officials were concerned mounting losses at the two companies, which own or guarantee almost half of the country's $12-trillion (U.S.) in outstanding home mortgage debt, was sapping their vitality and threatening to undermine them at a time other sources of housing finance have largely run dry.

"Our economy and our markets will not recover until the bulk of this housing correction is behind us," U.S. Treasury Secretary Henry Paulson said at a news conference. "Fannie Mae and Freddie Mac are critical to turning the corner on housing."

The two companies, publicly traded but also serving a government mission to support housing, were put in a conservatorship that allows their stock to keep trading but puts common shareholders last in any claims.

U.S. Secretary of the Treasury Henry Paulson, right, listens as Jim Lockhart, Director of the Federal Finanace Agency, speaks during a news conference, announcing that the government is taking control of mortgage finance companies Fannie Mae and Freddie Mac. (Joshua Roberts/Reuters)

Freddie Mac

Fannie Mae

Their top executives were ousted. Freddie Mac chief executive Richard Syron and Fannie Mae's CEO, Daniel Mudd, were replaced by David Moffett, a former top official at US Bancorp, and Herb Allison, formerly with Merrill Lynch and pension fund TIAA-CREF.

In addition, the U.S. Treasury will immediately take a $1-billion equity stake in each company in the form of senior preferred stock and if needed could inject up to $100-billion into each firm.

The government's senior preferreds stock would rank above both existing preferred and common shares and will carry warrants that could give the government an ownership stake of 79.9 per cent.

Treasury also set up a program under which it would buy mortgage-backed securities currently held by Fannie Mae and Freddie Mac to pump fresh funds into the mortgage market. It said it would begin buying MBS later this month, and it would have authority to make such purchases through Dec. 31, 2009.

The huge potential liabilities facing each company, as a result of soaring mortgage defaults, could cost U.S. taxpayers tens of billions of dollars, but Mr. Paulson stressed that the financial impacts if the two companies had been allowed to fail would be far more serious.

"A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance," Mr. Paulson said.

But more importantly, "Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe," he added in a televised announcement.

Several analysts said the move should help instill some confidence in shaky credit markets and lower mortgage costs.

"The government had to do something to eliminate uncertainty," said Peter Goldman, a principal with Front Barnett Associates in Chicago. "Anything that eliminates uncertainty in the credit markets is a good thing."

The Treasury Department said the plan to shore up the finances of the two government-sponsored enterprises, which have $1.6-trillion in debt outstanding, should not cost U.S. taxpayers money in the long run and could even return cash to the government coffers eventually.

The companies have suffered combined losses of nearly $14-billion in the last four quarters and large holders of their debt, including overseas central banks, have begun to show signs of increasing nervousness over their financial health.

Worries over their shrinking capital position led their regulator, the Federal Housing Finance Agency, to place them in conservatorship.

"As house prices, earnings and capital have continued to deteriorate, their ability to fulfill their mission has deteriorated," FHFA Director James Lockhart told the news conference. "They have been unable to provide needed stability to the market."

He said the companies lacked sufficient capital to continue taking losses while supporting the housing market at the same time.

Mr. Lockhart said dividends on both common and preferred stock would be eliminated, saving about $2-billion a year. He said that all lobbying activities of both companies would stop immediately. Both companies over the years made extensive efforts to lobby members of Congress in an effort to keep the benefits they enjoyed as government-sponsored enterprises.

The impact on existing common and preferred shares, which have slumped in value in the last year, will depend on how investors react to Mr. Paulson's assertion that they must absorb the cost of further losses first.

Mr. Paulson said that it would be up to Congress and the next president to figure out the two companies' ultimate structure and the conflicting goals they operated under - maximizing returns for shareholders while also being required to encourage home buying for low- and moderate-income Americans.

Federal Reserve Chairman Ben Bernanke said in a statement that he "strongly" endorsed the action. "These necessary steps will help to strengthen the U.S. housing market and promote stability in our financial markets," he said.

As part of the plan, FHFA will operate the companies until they are stabilized and the Treasury will extend financing to the companies, as well as to the Federal Home Loan Banks, through a new lending facility until Dec. 31, 2009, if needed.

In addition to the senior preferred stake Treasury is taking in the companies, it will immediately receive warrants for the purchase of some common stock.

The stock of the two companies has fallen more than 90 per cent in the past year and in recent months foreign investors have pared their holdings of the companies' securities.

Mr. Paulson had briefed both Democratic presidential nominee Sen. Barack Obama and Republican contender Sen. John McCain earlier during the weekend. Both candidates indicated they would support the plan, but wanted to ensure taxpayers were safeguarded and shareholders and management took a hit.