Can't live with them, can't live without them

The US government's rescue of Fannie Mae and Freddie Mac was done through gritted teeth. Stephen Foley asks if the two mortgage giants will continue to be seen as vital to the American dream, or left to sink or swim

Perhaps the smartest provision in the details of the deal for the US federal government to seize control of Fannie Mae and Freddie Mac was this one: a ban on the mortgage giants' political lobbying activities.

The two companies, brought to the brink of collapse by the housing market slump across the US, had the most-feared and successful lobbying operation in Washington DC, and there is no greater evidence of that than the fact they grew to such a bloated scale that they could threaten the fabric of global finance.

Fannie and Freddie are, after all, intensely political creatures. They were very profitable private companies, traded on the stock exchange in New York, but they operated with an explicit government mandate (to buy and sell mortgages, freeing up cash so lenders could help more Americans get on the property ladder) and with an implicit government guarantee (which meant that their bonds were seen to be as safe as US Treasuries).

When Hank Paulson, the US Treasury Secretary, announced last Sunday that he was putting them into a "conservatorship" under their federal regulator, he in effect seized control from shareholders and turned the two companies into arms of the federal government.

That means their future is now more political than ever – and whoever wins the presidential election on 4 November can expect to be embroiled in a furious struggle between politicians who think Fannie and Freddie are actually more important now than before, and those who want – in the words of Republican candidate John McCain – to "make them go away".

Fannie is formally the Federal National Mortgage Association and gets its cutesy nickname from the acronym FNMA. It was created in 1938 as part of the New Deal of Franklin D Roosevelt to help drag the US out of the Great Depression, and it was government-owned until 1968. After Fannie was privatised, Congress created a younger brother for it, to stimulate competition. The Federal Home Loan Mortgage Corporation (FHLMC) was quickly given a similarly cute nickname.

Together these companies are central to the American dream, ensuring that mortgages will always be readily available. What they don't do is lend money directly to borrowers. Instead, they buy and sell loans issued by other banks and mortgage lenders, creating a secondary market that has improved the availability of loans and brought down the cost of borrowing. Rather than waiting years for homeowners to pay off their mortgages, those original lenders immediately get a lump sum that they can use to fund more lending.

Critics say Wall Street is perfectly capable of running a secondary mortgage market these days. Fannie and Freddie, whose government guarantee enabled them to borrow money at lower than market rates, were simply unfair competition. That was certainly the view of the Bush administration, but its attempts to curtail the companies met with little success.

As the lobbyists showered money on, and presented their case to, Congressmen, the pair were allowed to take on more and more investment activities, swelling profits for shareholders as well as generating cash to expand their mission to subsidise the American dream.

As the housing market tanked, and millions defaulted on their mortgages, those investment activities have tanked too, contributing to losses of $14bn (£8bn) in the past year, with more to come. The already thin capital cushion that allowed Fannie and Freddie to operate safely has gone, and they need billions to continue to operate. The investors on Wall Street and in foreign governments, who bought the bonds that allowed Fannie and Freddie to trade, were starting to get cold feet. A July promise by Mr Paulson that he would not let the companies fail was bound to be tested sooner rather than later.

Fannie and Freddie together own or guarantee close to half of all the outstanding mortgages in the US, and their collapse would dry up what remains of the mortgage market, sending house prices spiralling further. Worse, almost $1 trillion of the two companies' debt is held by foreign governments, and a default could have triggered a flight of capital from the US, with disastrous consequences.

It was for that reason that the Bush administration ripped up years of laissez-faire economic policies last Sunday, cracked open the blank chequebook to write a first $6bn of emergency funding, and welcomed some $5.4 trillion of mortgage liabilities on to the US government's balance sheet.

Mr Paulson has had to offer taxpayer support through gritted teeth. He is a free-marketeer at heart, but as early as March he caved in to calls to let Fannie and Freddie expand their activities so they could step in to finance a wider variety of loans to the beleaguered mortgage market. Even in the deal bulldozed through over the heads of Fannie and Freddie's (now departed) chief executives, there are contradictions, not least the demand that they shrink their investment portfolios to a third of their current size – but only from next year. This year, they are allowed to expand their business further. No wonder: two in every three new mortgages are now financed by Fannie and Freddie. It all bolsters the case of those who say Wall Street cannot be trusted to provide mortgage finance in bad times as well as good.

"The announcement last week was a stop-gap measure," says Russell Jones, chief strategist at RBC Capital Markets. "It passes the buck to the next administration. The options are to turn them into proper nationalised institutions funded with real amounts of capital, or to spin them off again into the private sector. My guess is that they will be a persistent drain on the public purse. Any reform or fundamental change is a number of years down the track, and it will depend on the state of the financial markets and be dictated by the speed with which the housing market returns to a degree of health."

Democrats, traditionally much more sympathetic to Fannie and Freddie, may well find themselves in the ascendancy after the November Congressional election, and a Barack Obama presidency would give them added clout to insist on, if not a return to the status quo ante, at least a powerful, continuing, counter-cyclical role for the two companies.

And that talk last Sunday of forcing Fannie and Freddie to shrink their investment portfolios? Barney Frank, Democrat chairman of the House Financial Services Committee, insisted it will be for a future administration and a future Congress to decide on that – not for Mr Paulson to rule on what will happen long after he is out of power. "It's like me deciding what's going to happen in France," said Mr Frank. Touché.