To the rescue of Fannie & Freddie

Shares of many US regional banks plunged again yesterday, despite Henry Paulson's promised bail-out of America'stwin mortgage giants. By Stephen Foley

The promise of a United States government bail-out for the mortgage finance giants Fannie Mae and Freddie Mac failed to bring an immediate halt to the gathering panic over the American banking system.

Shares in many of the country's biggest regional banks were again plunging yesterday, and confusion reigned over just how many billions of dollars the Bush administration may be willing to hand to Fannie and Freddie to prop up the mortgage market.

The government's intervention prompted a brief rally by the stock market, but that was stamped out by nervous investors within the first hour of trading.

Late on Sunday, the US Treasury Secretary, the former Goldman Sachs chief executive Henry "Hank" Paulson, promised that the government and the Federal Reserve would each extend credit to prevent a liquidity crisis at Fannie and Freddie. That made explicit what had previously only been an implicit government guarantee behind the $5.2 trillion (£2.6 trillion) of mortgage debt insured by the two companies.

An immediate liquidity crisis appeared to have been averted, and a $3bn debt auction by Freddie Mac – part of its regular financing operations – was well-supported by investors. The government's backing ensures that Freddie and Fannie have access to cheap debt, which they use to buy and sell mortgages, providing an important prop to the mortgage market and ensuring that American homeowners have easy access to mortgages.

Politicians feared that their failure would have a seismic impact on an already reeling housing market, and Mr Paulson found eager support on Capitol Hill for the new arrangements, which could be put into law within the week. Congress is being asked to support an extended line

of credit to Fannie and Freddie from the government, and to grant permission for the government to buy equity in the two companies when they need to raise capital for new mortgage lending. The Federal Reserve is also going to be given regulatory powers over the two companies.

Fannie and Freddie have so far suffered $12bn in losses since the credit crisis began last summer, because of the plunging value of the homes underlying their mortgage-backed securities and fears of rising mortgage defaults.

Mr Paulson gave no clues as to how much the government might invest, if that became necessary, and officials yesterday suggested that they might not in the end have to put any cash in at all. The two companies each insisted they were well enough capitalised. But Fannie and Freddie shares swung about wildly as investors speculated on the terms of any bail-out, and some economists warned that the government needed to do more to reassure markets.

"Bold, creative, aggressive policy action is needed for the two government-sponsored entities to survive in their current capacity as private entities, and it is needed now," said Brian Bethune, the chief US financial economist at Global Insight. "The 'fire bri-gade' approach to dealing with the fallout from the extremely weak domestic economy is eroding general confidence in the US financial system. The Treasury will need to specify very soon how much capital it intends to infuse into the two entities, but this capital infusion needs to be very significant – perhaps as much as $20bn or higher for each – in order to reverse the negative psychology quickly and effectively."

Treasury officials had discussed the possibility of taking Fannie and Freddie under public control, but Mr Paulson insisted on Sunday that they should remain in their current form, namely as private companies able to tap outside shareholders.

The Goldman Sachs economist Jan Hatzius told clients that little had changed. "Ultimately, we do not view these measures, dramatic as they look, as either a turning point for the US housing market or as a sign that the downturn will be much worse than previously believed. They simply reaffirm our long-held – and widely shared – view that the government will do everything it can to avert a meltdown in the conforming mortgage market and will continue to stand behind the government-sponsored enterprises."

Hundreds of regional banks rely on selling their home loans to Fannie and Freddie, and a failure adequately to capitalise the pair could have knock-on consequences through the banking system. Already, some 90 of them are on a list of institutions being monitored by regulators. RBC's Capital Markets analyst, Gerard Cassidy, said more than 300 banks could fail in the next three years.

The concern came after Friday's collapse of IndyMac, the California mortgage lender which was seized by the Federal Deposit Insurance Corporation, the regulator, after a Northern Rock-style run on the bank in which panicked customers withdrew more than $1.3bn of deposits in 11 business days.

Shares in National City plunged 15 per cent on rumours that it, too, was suffering a run, and trading was halted until the bank issued a denial. Washington Mutual (WaMu) – identified by the analyst Dick Bove as being on the edge of the "danger zone" – collapsed by one-third. In a statement after trading ended, WaMu tried to scotch the stories by saying it was well-capitalised. In a separate report, Lehman Brothers predicted that WaMu would lose $26bn as a result of the credit crisis.

Tottering giants of the mortgage market

What exactly are Fannie Mae and Freddie Mac?

These giant mortgage finance companies are central to the American dream. They were set up by the government so that mortgages will always be readily available and so that more citizens can own their own homes. 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. This is because, rather than waiting years for homeowners to pay off their mortgages, those original lenders immediately get a lump sum they can use to fund more lending.

Where did they get those exotic names?

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 to drag the US out of the Great Depression, and it was government-owned until 1968. After Fannie Mae became a private company with shares traded on the stock market, Congress created for it a younger brother, to stimulate competition. The Federal Home Loan Mortgage Corporation (FHLMC) was quickly given a similarly cute nickname.

Are they another victim of sub-prime mortgage lending?

It's worse than that. Fannie and Freddie are actually banned from dabbling in the sub-prime market, which funded cut-price loans to the sorts of ultra-risky borrowers who are now defaulting in record numbers. Under heavy regulation by the federal government, they can only buy and sell traditional, mid-sized loans. But with house prices falling across the board in the US now, the assets that underpin even these loans have tumbled in value. That has led to big losses at both companies, and Wall Street is still trying to guess how big those losses might become.

Where do Fannie and Freddie get their money from?

They fund their purchases of mortgages from a pool of capital supplied by shareholders and raised from fees, and also by selling mortgage-backed securities. These securities are bonds which use the original home loans as collateral. Their mortgage-backed securities are popular because they come with a promise from the companies that they will step in to pay the interest if the underlying borrower defaults. Better still, because of their historic links to the government, the financial markets believe the securities are akin to US Treasuries – one step away from the safest investment in global finance.

What exactly is the US government's role?

Deliberately opaque. Every mortgage-backed security issued by Fannie and Freddie is stamped with a disclaimer which says it is not guaranteed by the US government. But no one has ever believed this. It is a sort of accounting trick to make sure all these mortgages don't look like liabilities for the US government, which has a big enough national debt as it is. The truth was out on Sunday night, when Hank Paulson, US Treasury Secretary, bounded in front of television cameras to say that the Treasury would extend billions of dollars in credit and may even hand cash directly to the companies in return for shares, if ever they were to get into difficulties.

Why was government action needed?

It is difficult to overstate the importance of these two companies. There are $12 trillion of US mortgage-backed securities in existence and Fannie and Freddie issued more than $5bn of them – and they have become even more important since the start of the mortgage crisis last year. Wall Street has lost its appetite for sub-prime and other mortgage investments, and home loans are being denied to all but traditionally creditworthy borrowers. Two-thirds of new mortgages are now backed by Fannie and Freddie.

Why was government action needed so urgently?

For the past week shares in Fannie and Freddie had fallen lower and lower, and there was a chance of a financial panic that might capsize the companies. The consequences of their failure were unthinkable. Mortgage lending would seize up, sending house prices dramatically lower and provoking a nasty recession. Worse, global markets may have become unstable and foreign governments – which have been helping to fund the US deficit by buying almost $1 trillion in Fannie and Freddie bonds, on top of all their holdings in US Treasuries – might pull their money out.

The Bush administration didn't have a choice?

No, and the promises Mr Paulson made on Sunday night were made through gritted teeth. Partly for ideological reasons, the Bush administration has been trying to whittle away the influence of Fannie and Freddie, believing that unfettered capital markets are better at providing mortgage finance than anything the federal government has a hand in. The administration also worried that the two companies were underfunding their operations, because the implicit taxpayer guarantee meant they could get away with a smaller capital cushion than other private companies.

Will the US taxpayer now end up with a big bill?

Perversely, promising to cough up taxpayer money to fund Fannie and Freddie makes it less likely that the money will be needed. The guarantees have relaxed bondholders, who are continuing to buy Fannie and Freddie debt and mortgage-backed securities without demanding punishing interest rates, so a short-term liquidity crisis looks implausible. The issue now is what happens further out as Fannie and Freddie look to raise billions of new capital to fund their next wave of mortgage purchases. Having the US Treasury as a backstop will reassure investors who would otherwise be too fearful to put up cash, but it is uncertain this will be enough. What is certain is that if the US government has to put taxpayer money into a capital raising later this year or next, it will have to extract a penalty from Fannie and Freddie's existing shareholders or face a political backlash. The global financial system appears to have averted another potential meltdown – but that doesn't mean Fannie and Freddie shareholders won't yet be wiped out.