Debt Rattle, September 7 2008: To Infinity and Beyond

Walker Evans Love Before Breakfast March 1936, Atlanta

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Update 1.00 PM EDT

Ilargi: Well, it’s done: Fannie and Freddie have been taken over, and James Lockhart, the man who only four months ago approved the books that are now judged to be disaster logs, and which allegedly prompted the bail-out, is the new boss. "Director of the new independent regulator, the Federal Housing Finance Agency, FHFA." Independent from what, exactly, you ask? How about: from you...

You know what they present as their main reason for all this? The interest of the taxpayer!!

Yes, "you lied, straight-faced while I cried", to quote Fannie’s great-aunt Maggie May.

In reality, the conditions have been created to slush untold billions from the Treasury into the GSE’s, stealthily over time, and from there directly to the Wall Street banks. That’s why Fannie and Freddie were founded, and that’s why they continue to exist. Government involvement in the housing market has one purpose, and one only: to raise real estate prices, and thus mortgage payments. Who profits? Well, not the buyers, obviously. Remember, this scheme was set up 70 years ago. Americans have paid far too much for their homes, in a scam initiated by their government, since 1938.

The GSE’s, oh irony, will now be more opaque than ever. They no longer have the ”open-your-books" burdens of public companies. Mind you, Fannie and Freddie had in reality stopped opening their books years ago.

To make today a real good reason for a party: Fannie and Freddie will keep on buying loans from factually bankrupt Wall Street banks, and issuing-mortgage backed securities for a long time. Yup, you’re right, that’s precisely what got them into trouble. Not before 2010 will that practice be changed, says Paulson.

And by 2010, who knows what happens? One thing's certain: Paulson will no longer be in office. He'll be back in the banking sector that will be able to suck trillions of dollars more out of the public trough because of the scheme he set up today.

It’s not so much a reason to party as it is a really good reason to drink, and drink a whole big lot, I would say. While you're at it, remember to procreate: this country will need a lot of extra children, just to pay off your debts.

Look: "Treasury will ensure that each company maintains a positive net worth". Yes, that’s for companies with trillions of dollars in -unrevealed- potential debt. The only thing that could prevent the Treasury, read: the taxpayer, from being responsible for that debt is for the housing markets to miraculously revive. That is what all this is based on. If it goes down further, we’ll need a whole new, and 180 degrees different, plan.

America, you have allowed a greedy sticky stinking set of hairy paws inside your pockets and your wallets, and this time they’re there to stay. You’re being told that it’s all in your best interest, and you are the ones swallowing it. The biggest bail-out, by a mile and a half, in the history of the human race.


Here’s, for starters, the full text of Hank Paulson’s press statement this morning.


Paulson Statement on U.S. Action on Fannie, Freddie: Text

Following is the text of a statement by U.S. Treasury Secretary Henry Paulson on the U.S. government takeover of mortgage companies Fannie Mae and Freddie Mac:

Good morning. I'm joined here by Jim Lockhart, Director of the new independent regulator, the Federal Housing Finance Agency, FHFA.

In July, Congress granted the Treasury, the Federal Reserve and FHFA new authorities with respect to the GSEs, Fannie Mae and Freddie Mac. Since that time, we have closely monitored financial market and business conditions and have analyzed in great detail the current financial condition of the GSEs - including the ability of the GSEs to weather a variety of market conditions going forward. As a result of this work, we have determined that it is necessary to take action.

Since this difficult period for the GSEs began, I have clearly stated three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers - both by minimizing the near term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure.

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 the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form.
The four steps we are announcing today are the result of detailed and thorough collaboration between FHFA, the U.S. Treasury, and the Federal Reserve.

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.
Throughout this process we have been in close communication with the GSEs themselves. I have also consulted with Members of Congress from both parties and I appreciate their support as FHFA, the Federal Reserve and the Treasury have moved to address this difficult issue.

Before I turn to Jim to discuss the action he is taking today, let me make clear that these two institutions are unique. They operate solely in the mortgage market and are therefore more exposed than other financial institutions to the housing correction. Their statutory capital requirements are thin and poorly defined as compared to other institutions. Nothing about our actions today in any way reflects a changed view of the housing correction or of the strength of other U.S. financial institutions.
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I support the Director's decision as necessary and appropriate and had advised him that conservatorship was the only form in which I would commit taxpayer money to the GSEs.

I appreciate the productive cooperation we have received from the boards and the management of both GSEs. I attribute the need for today's action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction. GSE managements and their Boards are responsible for neither. New CEOs supported by new non-executive Chairmen have taken over management of the enterprises, and we hope and expect that the vast majority of key professionals will remain in their jobs. I am particularly pleased that the departing CEOs, Dan Mudd and Dick Syron, have agreed to stay on for a period to help with the transition.

I have long said that the housing correction poses the biggest risk to our economy. It is a drag on our economic growth, and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us. Fannie Mae and Freddie Mac are critical to turning the corner on housing. Therefore, the primary mission of these enterprises now will be to proactively work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability.

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.
Treasury has taken three additional steps to complement FHFA's decision to place both enterprises in conservatorship.

First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. 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.

This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

Market discipline is best served when shareholders bear both the risk and the reward of their investment. While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses. The federal banking agencies are assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.

The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized." The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.

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. 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. The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.

The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.

Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS. During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we've seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers.

While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury's temporary authorities in December 2009.

Together, this four part program is the best means of protecting our markets and the taxpayers from the systemic risk posed by the current financial condition of the GSEs. Because the GSEs are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking.

The Preferred Stock Purchase Agreements minimize current cash outlays, and give taxpayers a large stake in the future value of these entities. In the end, the ultimate cost to the taxpayer will depend on the business results of the GSEs going forward. To that end, the steps we have taken to support the GSE debt and to support the mortgage market will together improve the housing market, the US economy and the GSEs' business outlook.

Through the four actions we have taken today, FHFA and Treasury have acted on the responsibilities we have to protect the stability of the financial markets, including the mortgage market, and to protect the taxpayer to the maximum extent possible.

And let me make clear what today's actions mean for Americans and their families. 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. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement.

A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today. While we expect these four steps to provide greater stability and certainty to market participants and provide long-term clarity to investors in GSE debt and MBS securities, our collective work is not complete. At the end of next year, the Treasury temporary authorities will expire, the GSE portfolios will begin to gradually run off, and the GSEs will begin to pay the government a fee to compensate taxpayers for the on-going support provided by the Preferred Stock Purchase

Agreements. Together, these factors should give momentum and urgency to the reform cause. Policymakers must view this next period as a "time out" where we have stabilized the GSEs while we decide their future role and structure.
Because the GSEs are Congressionally-chartered, only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission. The new Congress and the next Administration must decide what role government in general, and these entities in particular, should play in the housing market.

There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form. Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. And policymakers must address the issue of systemic risk. 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. We will make a grave error if we don't use this time out to permanently address the structural issues presented by the GSEs.

In the weeks to come, I will describe my views on long term reform. I look forward to engaging in that timely and necessary debate.

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Ilargi: There is a press conference at 11.00 AM EDT, featuring Hank Paulson and James Lockhart. They will undoubtedly present the big Fannie and Freddie bail-out. We will return later today to cover it. First a bit more on the run-up to the plan.

First, I noticed something disconcerting. There is a complete media lockdown on the talks, with the exception of the New York Times and the Washington Post. All media outlets have no option other than citing what these two papers write. Neither has exactly been on the forefront of economic reporting lately. And now they are the only forefront. Media control at its best, with anonymous leaks (rumored to be Paulson himself) and Barney Frank in his familiar role of hand puppet.

Another "strange" issue is James Lockhart, who sits in on all the meetings. He came in in 2006 as head of the OFHEO, the regulator for Fannie and Freddie.

In that position, in March 2008, he approved the books for both, after a wrestling match that went back pre-Lockhart, to 2001, due to the huge mess that these books had become. F&F did not fulfill their legal obligation to present financial statements for quite a few years.

Then, things changed. To quote the OFHEO:

"By March 2008, both GSEs were finally able to release timely, accurate financial statements and had otherwise cured many of their past problems....Finally, in May 2008, OFHEO determined that Fannie Mae had substantially completed its remediation, recognized that it had issued $7.4 billion in new capital, and therefore lowered the OFHEO-directed capital requirement to 15 percent above the statutory level."

Yes, that’s right, as soon as the books were approved, F&F were allowed to lower their reserve requirements even more. They were already ridiculously low, these "OFHEO-directed capital requirements", with a few billion dollars supporting $5-6 trillion in loans, and perhaps as much as $9 trillion in total debt. Ridiculously low, but not yet low enough for lenders to squeeze some more dupes.

That was four months ago. Now we find out that the Treasury and Morgan Stanley, upon seeing the same books just four months later, concludes that they are not at all in order, and there no "accurate financial statements". In fact, they are so full of lies and deceit, all legal provided you call it "creative accounting", that Fannie and Freddie need to be nationalized.

And who will be in charge, as regulator, now for the newly re-named FHFA, which is nothing but the OFHEO in a new dress? Well, James Lockhart of course. The same man who approved those books a few months ago and allowed (make that caused) the debt at F&F to rise even further.....

That's what I call a confidence booster. If you’re into massive fraud, that is.

If you think that the new Fannie and Freddie will be any better than the old ones, think again. Everything is being put in place to continue pushing the taxpayer down the downward slopes. To infinity and beyond.



Frank Confirms Treasury Intervention To Shore Up Fannie Mae, Freddie Mac

Rep. Barney Frank (D., Mass.) confirmed that Treasury Secretary Henry Paulson is planning government intervention to back troubled mortgage giants Fannie Mae and Freddie Mac.

The chairman of the House Financial Services Committee, said in a statement Saturday that Mr. Paulson "intends to use the powers that Congress provided it" in a law passed in July to keep Fannie Mae and Freddie Mac stable and functioning. But Mr. Frank said he didn't "know the details of the proposed interventions," and a Treasury spokeswoman declined to comment.

The Treasury Department is putting the finishing touches on a plan designed to shore up the companies, according to people familiar with the matter, a move that would essentially result in a government takeover of the mortgage giants.
The plan is expected to involve putting the two companies into the conservatorship of their regulator, the Federal Housing Finance Agency, said several people familiar with the matter. That would mean the government would take the reins of the companies, at least temporarily.

It is also expected to involve the government injecting capital into Fannie and Freddie. That could happen gradually on a quarter-by-quarter basis, rather than in a single move, one person familiar with the matter said. In addition, Treasury's plan includes a top-level management shakeup at both companies, according to people familiar with the plans. Daniel H. Mudd, chief executive of Fannie Mae, and Richard Syron, his counterpart at Freddie Mac, are expected to step down from their posts eventually.

An announcement could come as early as this weekend. Some details are still being worked out, and terms of the arrangement could change. Any move by Treasury would represent perhaps the most significant intervention by the government in the financial industry since the housing bust touched off turmoil in the credit markets a little more than a year ago.

From the $168 billion economic-stimulus package in February through the bailout of investment bank Bear Stearns Cos., the Bush administration and the Federal Reserve have taken an increasingly aggressive stance in responding to what has become one of the worst financial crises in decades.

Fannie and Freddie are vital cogs in the U.S. housing market. Their troubles have threatened to worsen the bursting of the housing bubble, which has led to a surge in foreclosures. A Treasury intervention could help Main Street borrowers by keeping interest rates on mortgages lower than they would be in the event of continued instability.

The Treasury's emergency powers to backstop Fannie and Freddie, which it won as the result of legislation passed by Congress in July, last until the end of 2009. A decision about their future role could be handed off to the next administration and the next Congress.

The woes of Fannie and Freddie mark a remarkable comedown for two of Washington's most powerful and feared institutions, known for their financial clout and no-holds-barred lobbying prowess. Fannie and Freddie shares, which were up during the regular session Friday, dropped 25% and nearly 20% respectively in the after-hours session.

Treasury's likely plan is supported by Federal Reserve Chairman Ben Bernanke and James Lockhart, chief of the Federal Housing Finance Agency, according to people familiar with the matter. On Friday afternoon, Messrs. Syron and Mudd were summoned to a meeting at the offices of the agency. Also attending were Mr. Bernanke and Treasury Secretary Henry Paulson.

The meetings Friday were in part aimed at getting Messrs. Mudd and Syron to agree to the plan, though their approval was not necessary, these people said. Mr. Mudd arrived for the meeting at 2:50 p.m., flanked by the company's general counsel, Beth Wilkinson, and Rodgin Cohen of Sullivan & Cromwell, one of the country's top banking lawyers. A few minutes later, Mr. Bernanke followed.

"We are making progress on our work," said Treasury spokeswoman Jennifer Zuccarelli, who declined to comment further. Spokesmen for Fannie and Freddie declined to comment on the expected Treasury moves. In July, Treasury won authority to intervene in the two companies, but it didn't say how or when it would act. Since then, federal officials have been working with bankers at Morgan Stanley to figure out how to prop up the mortgage giants.

Freddie and Fannie own or guarantee more than $5 trillion of mortgages. They have suffered combined losses of about $14 billion over the past four quarters as they make provisions for a wave of defaults. Investors worried that a government bailout would wipe out the value of existing stock, and those fears have sent the shares down about 90% from a year ago. Many U.S. banks as well as foreign governments own stock or debt in the two giants, meaning their financial woes could cause broad problems beyond the housing market.

Mr. Paulson's push to win authority was meant to reassure investors that the government wouldn't allow Fannie Mae and Freddie Mac to fail. But some believe it ultimately forced Treasury's hand. The federal government's involvement complicated the companies' already-difficult task of raising capital through the sale of common or preferred shares. Investors were leery of buying either while the government's intentions were unknown, because they feared the newly issued shares might become worthless as the result of federal action.

Bill Gross, chief investment officer of Pacific Investment Management Co., the large Newport Beach, Calif., bond manager, said in an interview Friday he believes private investors would buy new shares in Fannie and Freddie only if the Treasury acts first to bolster their capital. "Investors are saying, 'We want to see [the Treasury] in there with us,'" Mr. Gross said. The Treasury will have to "swim in the pool, not just be a lifeguard," he added.

Among the issues with which Treasury has been wrestling is whether to make an investment at such a low price that shareholders are effectively wiped out. Mr. Paulson is cautious about any plan that appears to benefit shareholders because he doesn't want the government to be seen as bailing out investors who for years profited from the companies' success.

The two companies were chartered by Congress to support the housing market, and therefore were seen as having the backing of the government. That allowed them to borrow funds at favorable rates close to those of U.S. Treasurys, even though they are both profit-making entities answerable to shareholders.

Sen. John McCain, the Republican nominee for president, has said his goal is to make the companies "go away" and to push for regulation that "limits their ability to borrow, shrinks their size until they are no longer a threat to our economy and privatizes and eliminates their links to the government." Sen. McCain supported giving Treasury the authority to backstop the firms but has said any use of taxpayer funds should be combined with an ouster of management and a ban on lobbying by the companies.

Sen. Barack Obama, the Democratic nominee, has said the companies are a "weird blend" and that "if these are public entities, then they've got to get out of the profit-making business, and if they're private entities, then we don't bail them out."

In a sign that some action was imminent, Freddie Mac changed its bylaws Thursday in a way that investors said could pave the way for Treasury or another large investor to take a controlling stake. Previously, Freddie Mac had a bylaw that prevented an investor with a stake of 20% or greater from voting without the approval of the other shareholders. It eliminated that restriction. Freddie Mac's board also put its protracted search for a chief executive on hold, according to people familiar with the situation.

Freddie Mac directors began interviewing CEO candidates last spring and hoped to pick someone by early September. The board was ready to offer the job to David Vitale, a longtime Chicago banking executive and the former head of the Chicago Board of Trade, according to a person familiar with the matter. Mr. Vitale had agreed to take the job and Freddie Mac ran its selection by its regulator but had not received a response.

In recent weeks, Treasury officials have been reaching out to foreign central banks and other overseas buyers of securities or debt sold by the two companies, to reassure them of the creditworthiness of these instruments. In one such conversation, at the end of August, the Treasury sought to reassure the Bank of Mexico, according to a person familiar with the matter, of the soundness of agency securities held by the bank. Treasury officials have also had similar conversations with Japanese investors who are buyers and holders of agency debt.

Despite turmoil in their shares, Fannie and Freddie have had little or no difficulty selling or rolling over their senior debt, though they have had to pay rates that include higher premiums over yields on Treasury bonds. The timing of Treasury's announcement could have been coordinated to land between the end of the Democratic and Republican party conventions and the convening of a congressional session next week.

Congress created Fannie as a government agency in 1938, during the Great Depression, to buy government-insured mortgages from lenders, providing them fresh money to make more loans. Fannie continued to function as a government-run agency during the 1940s and 1950s, even as it took steps toward privatization. In 1968, President Lyndon Johnson decided to turn Fannie into a shareholder-owned company.

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Takeover May Help Homebuyers, Hit Fan-Fred Shareholders

Homebuyers and holders of Fannie Mae and Freddie Mac debt are the likely beneficiaries of a U.S. Treasury plan to takeover the beleaguered mortgage giants, but it is less clear how shareholders will fare.

A capital infusion by the Treasury could harm investors in the firms' common and preferred stock in the near term, but may ultimately prove a boon to shareholders if the companies rebound, analysts said. "If the companies are stabilized and the crisis passes, the stock will be worth a lot," Peter Wallison, former general counsel to the Treasury and a frequent critic of the firms, argued.

Treasury is finalizing a plan to backstop Fannie and Freddie that will likely involve an injection of capital into the firms and a shake up of their top management, The Wall Street Journal reported on Friday. The intervention, which could be announced this weekend, is expected to put the companies into the conservatorship of their regulator, the Federal Housing Finance Agency. The companies' boards met on Saturday to discuss the plan.

In a statement on Saturday, House Financial Services Chairman Barney Frank (D., Mass.), said he knew from Treasury Secretary Henry Paulson only that the intervention was intended "to ensure the continued and stable functioning" of the firms. Fannie and Freddie have provided financing for 70% of mortgages originated in recent months, as purely private investors have fled the market.

Worries about the firms' ability to weather the housing crisis has pushed up their capital costs in recent weeks, causing mortgage rates to rise. An intervention to stabilize the firms would help to keep mortgage rates down, helping potential homebuyers, argued Brian Gardner, an analyst at Keefe, Bruyette & Woods.

The Treasury is widely expected to make whole investors in the firms' debt, which his held by central banks around the world. Treasury officials in recent conversations with such foreign investors assured them of the safety of their holdings.

Less certain is how the Treasury plan would affect the firms' stockholders. Under a conservator, as opposed to a receiver, shareholders are typically not wiped out, analysts said. However, if Treasury does not inject capital, the conservatorship might be a precursor to receivership, argued Mr. Wallison. In that case, the government might purchase the outstanding shares at a fraction of their market value.

Alternatively, the Treasury could recapitalize the firms via a new class of shares with priority over the existing shareholders. Then, it might shut off dividend payments to common and preferred shareholders in order to preserve capital in the firms. Such an approach could help to limit taxpayer losses and moral hazard -- or the risk that a federal bailout would spur more risky behavior.

Yet it would send the firms' share prices plunging to near-zero values for at least the time being, said Gerald Hanweck, a banking professor at George Mason University. He predicted it would be at least a couple of years before the firms would stabilize if they were allowed to remain in their current form.

Many suspect the Treasury will attempt to limit the damage to the preferred shares, which are widely held by banks, insurance companies and retail investors. Fannie and Freddie together have nearly $36 billion in preferred shares outstanding.

Banks, already grappling with soaring mortgage defaults, have lobbied the Treasury in recent weeks to protect their holdings of preferred shares in a potential bailout of the firms. "Between banks, insurance companies and retail investors, I'm sure the Treasury is walking very gingerly," Mr. Gardner said.

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Loan Giant Overstated the Size of Its Capital Base

The government’s planned takeover of Fannie Mae and Freddie Mac, expected to be announced as early as this weekend, came together hurriedly after advisers poring over the companies’ books for the Treasury Department concluded that Freddie’s accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter.

The proposal to place both mortgage giants, which own or back $5.3 trillion in mortgages, into a government-run conservatorship also grew out of deep concern among foreign investors that the companies’ debt might not be repaid. Falling home prices, which are expected to lead to more defaults among the mortgages held or guaranteed by Fannie and Freddie, contributed to the urgency, regulators said.

The details of the deal have not fully emerged, but it appears that investors who own the companies’ common stock will be virtually wiped out; preferred shareholders, who have priority over other shareholders, may also wind up with little. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

While it is not yet possible to calculate the cost of the government’s intervention, it could rise into tens of billions of dollars and will probably be among the most expensive rescues ever financed by taxpayers. The takeover comes on the heels of a rescue of the investment bank Bear Stearns, which was sold to JPMorgan Chase in a deal backed by taxpayer dollars. Already, the housing crisis has cost investors and consumers hundreds of billions of dollars.

Both presidential nominees expressed support for the government’s plans to take over the companies. The chief economic adviser to Senator John McCain, Republican of Arizona, who has long been critical of the mortgage finance giants, said on Saturday that Mr. McCain considered it an unfortunate but necessary step.

Senator Barack Obama, Democrat of Illinois, said as he campaigned in Indiana on Saturday that not acting could place the housing market in further distress. “These entities are so big and they are so tied into the housing market that it is probably true that we have to take steps to make sure they don’t just collapse,” Mr. Obama told an audience in Terre Haute, Ind. But he added that the government needed to take steps to guard against Fannie Mae and Freddie Mac ultimately profiting from the government assistance.

The big question now is whether the federal government’s move to take over Fannie and Freddie will restore investor confidence in the nation’s credit markets, help stabilize the stock market and keep loans flowing to creditworthy borrowers.

Fannie and Freddie, by buying mortgages, provide banks and other financial institutions with fresh money to make new loans, a vital lubricant for the housing and credit markets. As a result of the government’s intervention, the cost of borrowing for Fannie Mae and Freddie Mac should decline, because the government will be insuring their debts. Equally important, because the government is backing the companies, they will continue to buy and selling home loans.

But the plan will probably do little to stop home prices from falling further. And foreclosures are almost certain to rise. Just a week ago, Treasury officials were still considering a wide variety of options for Fannie Mae and Freddie Mac, ranging from doing nothing to taking over the companies completely, according to people with knowledge of those discussions.

The Treasury secretary, Henry M. Paulson Jr., who won authority from Congress last month to use taxpayer money to bolster the companies, always maintained that he hoped never to use that power. But, as the companies’ stocks continued to languish and their borrowing costs rose, some within the Treasury Department began urging Mr. Paulson to intervene quickly.

Then, last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined, according to people briefed on those findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies’s capital resources and financial stability.

Indeed, one person briefed on the company’s finances said Freddie Mac had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of this year, which would not need to be disclosed until early 2009. Fannie Mae has used similar methods, but to a lesser degree, according to other people who have been briefed.

On Friday, executives from Fannie Mae and Freddie Mac were ordered to appear in the offices of their regulator, James B. Lockhart, in separate meetings, and were told that regulators were exercising their authority to place the companies in conservatorship, which would allow for uninterrupted operation of the companies but would put them under the control of Mr. Lockhart.

The details of those plans continued to be worked out on Saturday, when the Federal Reserve chairman, Ben S. Bernanke, met with Mr. Paulson, Mr. Lockhart and key company executives in Washington. While Freddie Mac’s accounting woes make it easier for regulators to force the company into conservatorship, there was more resistance from Fannie Mae, according to people familiar with the discussions.

Once the government took action against Freddie Mac, however, confidence in Fannie Mae would certainly waver. Given Fannie Mae’s declining financial condition, the company has few options but to concede to the government’s demands. Both companies have the option of challenging the conservatorship and asking for a judicial review.

Accusations of questionable accounting are not new for either company. Earlier this decade, both companies paid large fines and ousted their top executives after accounting scandals. Freddie Mac’s current chief executive and chairman, Richard F. Syron, joined the company in 2003 after the former managers revealed they had manipulated earnings by almost $5 billion.

The following year Fannie Mae’s chief executive, Daniel H. Mudd, was promoted to the top spot after that company was accused of accounting errors totaling $6.3 billion. People familiar with Treasury’s plan say that both men, as well as other executives, will be forced to leave the companies.

The accounting issues that brought so much urgency to the bailout appear to center on Freddie Mac’s capital cushion, the assets that regulators require them to keep on hand to cover losses. The methods used to bolster that cushion have caused serious concerns among the companies’ regulator, outside auditors and some investors.

For example, while Freddie Mac’s portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices.

Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value. But other financial institutions have written down similar securities, to comply with “mark-to-market” accounting rules. Freddie Mac holds roughly twice as many of those securities as Fannie Mae.

Freddie Mac and Fannie Mae have also inflated their financial positions by relying on deferred-tax assets — credits accumulated over the years that can be used to offset future profits. Fannie maintains that its worth is increased by $36 billion through such credits, and Freddie argues that it has a $28 billion benefit.

But such credits have no value unless the companies generate profits. They have failed to do so over the last four quarters and seem increasingly unlikely to the next year. Moreover, even when the companies had soaring profits, such credits often could not be used. That is because the companies were already able to offset taxes with other credits for affordable housing.

Most financial institutions are not allowed to count such credits as assets. The credits cannot be sold and would disappear in a receivership. Removing those credits from assets would probably push both companies’ capital below the regulatory requirements.

Regulators are also said to be scrutinizing whether the companies were trying to manage their earnings by waiting to add to their reserves. Both companies have gradually increased their reserves for loan losses — Fannie’s reserves today stand at $8.9 billion, and Freddie’s at $5.8 billion.

Other companies, like private mortgage insurers, have been quicker to identify large losses and have set aside much greater amounts. Fannie and Freddie have dribbled out bad news with each quarterly announcement, suggesting they may be trying to manage this process.

Finally, regulators are concerned that the companies may have mischaracterized their financial health by relaxing their accounting policies on losses, according to people familiar with the review. For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were two years late. As a result, tens of thousands of loans have not been marked down in value.

The companies have injected their own capital into pools of securities containing these loans, arguing that their new policies are helping more borrowers. Under conservative accounting methods, changing these policies would not have any impact on the companies’ books. However, people briefed on the accounting inquiry said that Freddie Mac may have delayed losses with the change.

“We have just had to nationalize the two largest financial institutions in the world because of policy makers’ inaction,” said Josh Rosner, an analyst at Graham Fisher, an independent research firm in New York, and a longtime critic of the government-sponsored enterprises. “Since 2003, when these companies’ accounting came under question, policy makers have done nothing. Even though they had every reason to know that the housing market’s problems would not be contained to subprime and would bring down the houses of Fannie and Freddie.”

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Mortgage Giants Agreeable to Rescue Plan, but Its Cost Is Unknown

Fannie Mae and Freddie Mac agreed on Saturday afternoon to the Bush administration’s plan to rescue them, people briefed on the plan said. Under the plan, the Treasury Department will buy billions of dollars in new mortgage securities issued by the companies and inject an unknown amount of capital into them in quarterly installments, according to these people.

On Sunday, the government plans to announce that it will take control of the mortgage finance giants, remove the top executives and their boards, and appoint a conservator to begin to nurse them back to health. Senior government officials including Treasury Secretary Henry M. Paulson Jr., Federal Reserve Chairman Ben S. Bernanke, and James Lockhart, the top regulator for the companies, informed their top executives about the plan in meetings on Friday and Saturday.

The moves by the Bush administration hold the prospect of becoming the biggest government-funded bailout of private industry in American history. They would put the federal government in control of institutions that finance or guarantee about half of all the mortgages in the country.

The administration is not expected to say how much the bailout ultimately will cost, in part because it does not know how much the Treasury will be able to ultimately sell the assets for. It could be politically uncomfortable to put a price tag on a huge bailout, only two months before the presidential election. The Congressional Budget Office said two months ago that it was impossible to say how much a bailout would cost, but estimated $25 billion based on the companies’ projected losses at the time.

The government, which will replace the top management and boards of both companies, is hoping to restore the health of the companies. Treasury officials have assured lawmakers that at least for the short term, they intend to make Fannie and Freddie as strong as possible so they can help pull the housing market out of its slump.

But shareholders of both companies will suffer. The companies would stop paying any dividends on their common shares, and any new capital provided by the Treasury Department would have financial priority over the existing preferred and common stock.

Treasury officials and lawmakers in Congress remained tight-lipped about the plan on Saturday, but several key Democrats expressed cautious support. “I am pleased by the secretary’s strong re-affirmation that the vital roles these institutions play in our nation’s housing markets must continue,” said Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee.

But Mr. Frank and others briefed on the plan said that they still had few details and had many questions about how it would work. It was unclear, for example, what the Treasury Department would allow the companies to do with any capital that it provided them. One basic alternative for using the money would be to shore up the companies’ balance sheets and shield them from insolvency. By some measures, Freddie Mac’s losses have already brought it to the brink of insolvency, and Fannie Mae is only slightly less vulnerable.

Using money from the Treasury Department to rebuild the companies’ capital cushions would make them stronger and reduce some of the uncertainty about their prospects. But the Bush administration also wants to provide a lift to the mortgage markets, and Fannie and Freddie are the only significant buyers of mortgages at the moment. If they are prohibited from using their capital to buy and hold more loans, they would be less able to provide money for the housing markets.

Administration officials are hoping that the Treasury Department’s decision to take control of the companies and explicitly stand behind their debt will provide a much more important lift as investors become confident about Fannie and Freddie securities. Analysts note that Fannie and Freddie securities now trade at a fairly wide premium over comparable Treasury bills, mainly because of investor anxiety about the two companies’ ability to make good on their debts.

Reducing that interest rate premium by one percentage point, according to some estimates, could reduce the effective cost of buying a home by as much as 15 percent.

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A History of Public Aid During Crises

Despite decades of free-market rhetoric from Republican and Democratic lawmakers, Washington has a long history of providing financial help to the private sector when the economic or political risk of a corporate collapse appeared too high.

The effort to save Fannie Mae and Freddie Mac is only the latest in a series of bailouts that stretch back to the rescue of the military contractor Lockheed Aircraft Corporation and the Penn Central Railroad under President Nixon and the rescue of Chrysler in the waning days of the Carter administration through the more recent salvage of the savings and loan system in the late 1980s.

Now, with the federal government preparing to save Fannie and Freddie only six months after the Federal Reserve orchestrated the rescue of Bear Stearns, it appears that the mortgage crisis has forced the government to once again shove ideology aside and get back into the bailout business.

“If anybody thought we had a pure free-market financial system, they should think again,” said Robert F. Bruner, dean of the Darden School of Business at the University of Virginia. “The government and private financial institutions are cheek by jowl in their engagement with the flows of money in the economy, so regulators have a keen interest in the survival of financial institutions.”

He added that these types of rescues typically came when the economy was weakening or was already in a recession, as was the case in the 1970s. Referring to the economist Joseph Schumpeter’s description of a recession as a cold shower for economic excesses, Mr. Bruner said, “We’re witnessing a correction for all the mistakes of the recent boom.”

The closest historical analogy to the Fannie-Freddie crisis is the rescue of the Farm Credit and savings and loan systems in the late 1980s, said Bert Ely, a banking consultant who has been a longtime critic of the mortgage finance companies as well as a frequent participant in discussions at the American Enterprise Institute, a conservative policy group in Washington.

The savings and loan bailout followed years of high interest rates and risky lending practices and ultimately cost taxpayers roughly $124 billion, with the banking industry kicking in another $30 billion, Mr. Ely said.
Still, Mr. Ely makes a distinction between the rescue of Fannie and Freddie and the thrifts versus the earlier aid packages for Chrysler and other industrial companies.

“They didn’t have a federal nexus, they weren’t creatures of the federal government,” he said. “The way Chrysler and others were handled was inappropriate and could have been dealt with under the bankruptcy code.”

In the Chrysler case, President Carter and lawmakers in car-building states helped push through a package of $1.5 billion in loan guarantees for the troubled carmaker, while also demanding concessions from labor unions and lenders. Similarly, Lockheed was saved by loan guarantees in 1971, rather than the kind of direct infusion of billions of dollars, as saving the mortgage finance companies would likely require.

This effort is also different because of the potential fallout for the broader economy and especially the beleaguered housing sector if it were to not succeed. Unlike a particular auto company or even a major bank like Continental Illinois National Bank and Trust, which was bailed out in 1984, “we depend on Fannie and Freddie for funding almost half of our mortgage market,” said Thomas H. Stanton, an expert on the two companies who also teaches at Johns Hopkins University.

He added, “The government has many less degrees of freedom in dealing with these companies than in the earlier bailouts.” Indeed, even in an era when both Democrats and Republicans agree on broad free-market principles, “nobody ever wants to play Russian roulette,” says Jonathan Koppell, director of the Millstein Center for Corporate Governance and Performance at Yale. “It creates a massive moral hazard for the future, but nobody wants to be the one at the helm when the market entered Armageddon.”

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EU's Almunia Expects European Economy to Recover in Early 2009

European Union Economic and Monetary Affairs Commissioner Joaquin Almunia said economic growth in the region will recover in 2009 after a slowdown in the second and third quarters.

Economic growth will pick up "at the beginning of next year," Almunia told reporters at a press conference in Cernobbio, Italy, today. "In any case, the forecasts are surrounded by extremely high levels of uncertainty" and Europe is currently facing a "serious slowdown" in growth, he said.

Europe's economy contracted 0.2 percent in the second quarter and may not recover in the third as exports falter and consumer spending slumps. Still, a 27 percent drop in oil prices from a July 11 record of $147.27 a barrel leaves companies with more money to spend just as a weaker euro underpins exports.

"We're in a better position to weather the situation than three or four years ago," Almunia said, referring to improved fiscal positions across Europe.

Luxembourg Finance Minister Jean-Claude Juncker, who chairs a group of counterparts from the euro-area, said this week the region's economic situation is "not good" and the EU will this month cut its growth forecasts. The European Commission's gross domestic product forecast for 2008 will be cut to as low as 1 percent when it publishes new predictions next week, Juncker said Sept. 4. That compares with a previous forecast for growth of 1.7 percent.

Almunia also said European governments must work together to "avoid an inflationary spiral." He added that the decline in oil prices won't affect inflation positively in the short term, while damping inflation pressure over the medium term.

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France May Have to Revise Down Growth Forecasts, Lagarde Says

France may have to cut its growth forecasts after the economy shrank in the second quarter and because of "current economic circumstances," Finance Minister Christine Lagarde said.

"It is possible that we will have to do it in the light of the various numbers that we have landing on our desk," Lagarde said today in an interview in Cernobbio, Italy. "A lot of numbers are not good. Whether we look at industrial production or surveys and polls of purchasers and heads of companies, it is pretty much downwards."

The French economy contracted for the first time in more than five years in the second quarter as exports declined and companies cut spending. Gross domestic product of the euro- region's second-largest economy fell 0.3 percent from the first quarter, when it rose 0.4 percent, the Paris-based national statistics office Insee said Aug. 14.

Any revision to the official forecast of 1.7 percent to 2 percent growth for this year would come during preparation of the 2009 budget, Lagarde told the LCI TV channel on Sept. 1. Europeans' confidence fell more than forecast last month as the economy teetered on the brink of a recession. An index of executive and consumer sentiment in the economic outlook dropped to 88.8 from 89.5 in July, the European Commission in Brussels said on Aug. 29.

"The price of oil has gone down tremendously in the last six weeks and that is going to help the economy" to pick up, Lagarde said today. "It is a mixed picture where we have a few gray and dark clouds over the horizon, but there is a lining in every cloud. I think there is a little bit of that sort of lining here and there."

A 27 percent drop in oil prices from a July 11 record of $147.27 a barrel leaves companies with more money to spend just as a weaker euro underpins exports. The dollar this week rose to the highest this year against the euro. "The fact that the dollar is strengthening against the euro is not bad either," the minister said. "Clearly, it will help those European enterprises that export outside the euro zone to be more competitive."

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