Plan to take over mortgage giants put in high gear
Posted on Sunday, September 7, 2008
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 Mac’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 Mae and Freddie Mac, contributed to the urgency, regulators said.
The Treasury plans to put Fannie Mae and Freddie Mac into a conservatorship, a legal status akin to Chapter 11 bankruptcy, and pump capital into the companies, House Financial Services Committee Chairman Barney Frank, D-Mass., said in an interview after being briefed by Treasury Secretary Henry Paulson.
The government would make periodic injections of funds by buying convertible preferred shares or warrants in the companies as needed, avoiding large upfront taxpayer costs, according to a person briefed on the plan.
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 prior- ity over other shareholders, may also end up with little. Holders of debt, including many foreign central banks, are expected to receive government backing.
Holders of the common and preferred stock are “very unlikely to come out of this at all happy,” Frank said.
Paulson and two other regulators were working Saturday on the plan to put the troubled mortgage finance companies into a conservatorship and to remove Fannie Mae Chief Executive Officer Daniel Mudd and Freddie Mac CEO Richard Syron, according to Frank.
The action is planned for today, according to several sources.
The government is expected to control the two companies for at least a year as it evaluates and debates whether Fannie Mae and Freddie Mac should remain government-run entities or be restructured in some fashion, Frank said.
While it is not yet possible to calculate the cost of the government’s intervention, the Congressional Budget Office estimated it could cost taxpayers about $ 25 billion. OBAMA, McCAIN BACK PLAN Both presidential nominees expressed support for the government’s plans to take over the companies as necessary.
Sen. Barack Obama, D-Ill., said as he campaigned in Indiana 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,” Obama told an audience in Terre Haute on Saturday.
But he added that the government needed to take steps to guard against ultimately profiting from the government assistance by the Federal National Mortgage Association, or Fannie Mae, and Federal Home Loan Mortgage Corp., or Freddie Mac.
Sen. John McCain, R-Ariz., has long been critical of the mortgage finance giants. His running mate, Gov. Sarah Palin, spoke out from a rally in Colorado Springs, Colo. “Fannie Mae and Freddie Mac, they’ve gotten too big and too expensive to the taxpayers,” Palin said. “The McCain-Palin administration will make them smaller and smarter and more effective for homeowners who need help.” The big question now is whether the federal government’s move to take over the mortgage giants will restore investor confidence in the nation’s credit markets, help stabilize the stock market and keep loans flowing to creditworthy borrowers.
Fannie Mae and Freddie Mac, 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.
Because the government is intervening, 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 sell home loans.
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 the discussions. Paulson concluded in recent weeks that even a one-time infusion of government cash would not be enough to restore investor confidence unless it represented a truly massive amount, which he was reluctant to commit. Paulson, who won authority from Congress last month to use taxpayer money to bolster the companies, always maintained that he hoped never to use the Treasury’s power. But, as the companies’ stocks continued to languish and their borrowing costs rose, some within the Treasury Department began urging Paulson to intervene quickly.
OVERSTATED CAPITAL 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 the findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the company’s capital resources and financial stability. 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.
Representatives of both companies did not return calls or declined to comment.
On Friday, executives from Fannie Mae and Freddie Mac were ordered to appear in the offices of their regulator, James 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 Lockhart’s control.
Both companies have agreed to the takeover, sources said. Executives of the two firms met with Paulson and Federal Reserve Chairman Ben Bernanke on Saturday.
Instead of making a one-time cash infusion to keep the companies afloat, the government will make quarterly investments, to the degree that market conditions require. That way, in Treasury officials’ view, investors can have confidence of a ready source of cash if the firms need it, but taxpayers need not be put on the hook any more than necessary. The companies’ shares are off about 90 percent from their highs in the past year. ACCOUNTING WOES NOT NEW 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.
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.
Syron, Freddie Mac’s current chief executive and chairman, joined the company in 2003 after the former managers revealed they had manipulated earnings by nearly $ 5 billion. The following year Fannie Mae’s chief executive, Mudd, was promoted to the top spot after the 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 ’ regulators, 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 intended to hold the loans to maturity, meaning they would be worth more, and they needed 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.
DEFERRED-TAX ASSETS Freddie Mac and Fannie Mae have also inflated their financial positions by relying on deferredtax assets, credits accumulated over the years that can be used to offset future profits. Fannie Mae maintains that its worth is increased by $ 36 billion through such credits, and Freddie Mac argues that it has a $ 28 billion benefit. But such credits have no value unless the companies generate profits. 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 Mae’s reserves today stand at $ 8. 9 billion, and Freddie Mac’s at $ 5. 8 billion. Information for this article was contributed by Gretchen Morgenson and Charles Duhigg of The New York Times; by Alan Zibel, Charles Babington and Terence Hunt of The Associated Press; by Zachary A. Goldfarb, David Cho, Binyamin Appelbaum, Davis S. Hilzenrath, Neil Irwain, Michael D. Shear and Peter Slevin of The Washington Post; and by Dawn Kopecki, Alison Vekshin, Brian Faler, John Brinsley, Laura Litvan, Christine Harper and Kim Chipman of Bloomberg News.
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