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U.S. govt. may buy Freddie debt if banks won't

Section: Daily Dispatches

Freddie Mac's Next Hurdle:
Raise Cash

Treasury Working to Make Sure Debt Sale Succeeds

By Jeffrey H. Birnbaum and Steve Mufson
Washington Post
Sunday, July 13, 2008

Treasury Department officials were working the telephones yesterday to make sure that Freddie Mac, one of the nation's two troubled mortgage giants, will be able to sell $3 billion of its securities tomorrow in a previously scheduled sale that has now become a crucial test of investor confidence.

Though officials said they were optimistic the sale would be a success, anything less would pose new questions about how far the federal government is willing to go to prop up Freddie Mac, its sister Fannie Mae, and other faltering financial enterprises.

Officials spoke yesterday with major banks that normally purchase securities, like the short-term debt offered by Freddie, to ensure these firms still plan to place bids tomorrow. This was part of an effort by officials at Treasury, the Federal Reserve and other agencies this weekend to gauge market sentiment and check that investors still have faith in Freddie Mac and Fannie Mae after the steep decline in their stock prices last week.

At the same time, Treasury officials were considering several options to backstop the sale in case they discover that interest in the securities is flagging, according to sources familiar with the discussions. Under one alternative, the Treasury or Fed would purchase the securities directly.

Other possibilities are allowing the Federal Reserve Bank of New York to buy the debt indirectly through private brokers or asking private firms to purchase the debt while extending to them either a public or private assurance that the government would back the securities if Freddie were ultimately unable to cover its obligations.

As the credit crisis has battered one financial giant after another, federal officials have taken steps that have put the government, and potentially taxpayers, on the line behind private institutions.

Last week's gut-wrenching ride for shareholders of Fannie Mae and Freddie Mac raised speculation about whether the Bush administration might be forced to step up again, either by taking direct control of the firms or by pumping fresh capital into them, perhaps in return for stock and a promise to restructure the companies.

It would be only the latest in a series of unusual interventions. In March, the Fed extended a $30 billion credit line to orchestrate JP Morgan Chase's purchase of troubled investment bank Bear Stearns. The Fed then let other investment banks borrow directly from the Fed at favorable rates. And Friday the Federal Deposit Insurance Corp. seized control of California-based IndyMac Bank with plans to liquidate its assets at a cost that could wipe out more than 10 percent of the FDIC's funds.

"Someday this capitalistic economy, or what we used to call the capitalistic system, needs to get back on track and that means failure," said Lee Hoskins, former president of the Federal Reserve Bank of Cleveland. "You can't have risk-taking without failure."

But if there is a limit to the government's willingness to back financial giants, now might not be the best time to find out.

Even long-time critics of Fannie Mae and Freddie Mac -- unusual hybrids with private shareholders, a public mission, a congressional charter and implied government backing -- say that the federal government has no option but to assure their viability because they are so central to already troubled mortgage and housing markets and hence to the overall economy.

The $5.2 trillion in mortgages owned or guaranteed by Fannie Mae and Freddie Mac dwarfs the size of the savings and loan institutions taken over by the federal government in the late 1980s or even the big Japanese banks that required government assistance there in the 1990s. These have been two of the biggest post-Depression financial rescue efforts.

Moreover, at a time when commercial banks have become cautious about new loans, Fannie Mae and Freddie Mac continue to provide liquidity for more than 70 percent of new home mortgages.

In addition, banks, pension funds and other institutions as well as foreign governments hold large amounts of the two firms' bonds. Any suggestion that the U.S. government wasn't standing behind the firms might cause widespread losses and further caution in credit markets.

"We have no options like we did with S&Ls. These two are so large and so vital to the continued operation of the mortgage markets that the government must back them," said Peter Wallison, a longtime critic of implicit government backing for the firms and general counsel of the Treasury under President Reagan. "We should be grateful that they still have sufficient capital to be considered by their regulator to be viable and that capital markets see Fannie and Freddie as backed by the government."

Many economists, citing the U.S. thrift and Japanese banking crises, are urging the Bush administration to seize this troubled moment to try to change the nature of Fannie Mae and Freddie Mac or gradually shrink their size to reduce the economy's exposure to them. These economists warn that U.S. government efforts to prop up S&Ls and Japanese efforts to prop up big banks years ago only extended and increased the size of those financial debacles.

From the mid-1980s to mid-1990s, the U.S. government seized more than 1,000 thrift institutions and sold off more than $500 billion in assets at a taxpayer loss of $124 billion. The size of those assets would be equal to approximately $830 billion today and the taxpayer loss about $165 billion. In Japan, the government gave "regulatory forbearance" to insolvent banks, which deteriorated even further before more painful measures were taken.

At the same time, economists and financial analysts caution against hasty measures. The past week created a sense of urgency as Fannie Mae shares plunged 45 percent for the week to barely a seventh of its 52-week high and Freddie Mac shares sank 47 percent for the week to one-ninth of its 52-week high. Based on the recent disclosure statements, investors in big mutual funds managed by Capital Research Global Investors, Fidelity Investments, Legg Mason and American Funds have suffered heavy losses. Fannie Mae and Freddie Mac have lost more than $100 billion of market value in the past year.

But unlike Bear Stearns, the two mortgage firms do not have a liquidity or cash crisis. There has been no run on the bank like the one that put Bear Stearns at the mercy of the Fed. The gap between Fannie Mae bonds and Treasury bonds actually narrowed Friday, a vote of confidence on the part of people willing to provide money for the firm to buy more mortgages from banks.

More worrisome is the sharp rise in delinquent home mortgages held or guaranteed by Fannie Mae and Freddie Mac, and that will result in some losses. But the quality of the big bundles of residential mortgages is far better than the commercial loans at many of the S&Ls or Japanese banks that failed during the earlier financial crises. At one point, the bad loans on the books of Japanese banks totaled more than a quarter of the Japanese economy, said Adam Posen, deputy director of the Institute of International Economics. Although Fannie Mae and Freddie Mac loans total 45 percent of the U.S. economy, a relatively small percentage of those are bad and the quality of new loans is probably better than the old ones now that lenders are more cautious.

Citigroup analyst Bradley Ball issued a "flash" report Friday urging regulators at the Office of Federal Housing Enterprise Oversight "to step up and express its support for management, reminding investors that the GSEs [government sponsored enterprises] continue to perform their mission and are adding less risky new business with solid margins."

If a rescue were needed, its cost would depend on the strategy used.

Much of the stock market's anxiety about the firms is linked to the regulatory requirement that the firms revise the estimated market value of the $5.2 trillion of mortgages they own or guarantee to reflect likely defaults by homeowners. On paper, this has led to big losses. Because no one knows how many homeowners will be delinquent on loans, it isn't clear whether Fannie Mae and Freddie Mac will do better -- or worse -- than expected.

Freddie Mac is planning to raise $5.5 billion by selling a combination of common and preferred stock and may suspend part of its dividend, analysts said. Many financial experts say the current market value of those mortgage bundles is lower than it should be.

If a crisis of investor confidence made it impossible to raise that money, the administration has several options. One would be to swap a portion of the troubled securities for Treasury bills, removing the immediate need to bolster capital. The cost of this approach would be whatever the losses might eventually be on the mortgage securities, possibly as little as a few billion dollars this year.

Another course would be to give the firms access to the Fed's discount window.

In the most extreme case, however, the administration could seize control, effectively nationalizing the firms and taking on their obligations. To the extent that there are losses on the firms' portfolios of loans and guarantees, those losses would add to the federal deficit. A loss of 1 percent, hypothetically, could add $50 billion to the deficit. There would be a small amount of offsetting income.

If the administration decided to curtail or shrink Fannie Mae and Freddie Mac at the same time, that could add wider economic costs, driving up unemployment and reducing federal and local government tax receipts further.

Another option would be for the administration to inject capital in exchange for shares with preference over others in receiving dividends or retaining equity value. Hoskins said that one condition of doing that should be to clearly eliminate the implicit federal guarantee for future loans. Benjamin Friedman, a Harvard University economist, would want the federal government to wipe out the remaining equity interest of existing shareholders.

Ultimately, however, any rescue plan would have to weigh the impact on the future housing market. Friedman said that removing the implicit government guarantee or shrinking the firms could change lending risk assessments and "the whole mechanism we built up over the past 30 years for channeling savings into debt against houses is going to have to be either reconstituted or the market will charge a higher interest rate."

He said that would mean fewer homes would be bought and built and there would be a change in "the ethos of the United States," which has always valued owner-occupied housing.

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