Mortgage giants draw aid package

WASHINGTON —  Acting to prevent a severe disruption of the mortgage market, the federal government stepped in Sunday with plans for a sweeping aid package designed to bolster confidence in battered home-loan giants Fannie Mae and Freddie Mac.

The Bush administration said it would ask Congress to authorize the Treasury Department to lend Fannie and Freddie more money than current limits permit and buy stock in the two companies.

Also Sunday, the Federal Reserve agreed to permit the companies to borrow directly from the central bank, as investment firms were allowed to do after the near-collapse of Bear Stearns Cos. in March. The money would tide Fannie and Freddie over while the administration and Congress rush the emergency measures through.

Both the companies and the government said they did not fear a collapse but that assurances were needed to soothe Wall Street, where the companies’ shares lost nearly half their value last week.

“Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies,” Treasury Secretary Henry M. Paulson Jr. said in disclosing the administration’s plan. “Their support for the housing market is particularly important as we work through the current housing correction.”

The two own or guarantee nearly half of the nation’s $12 trillion in mortgage debt, and the new proposals would allow them to borrow billions of dollars, both to shore up their finances and to expand.

“This is basically a safety net,” said Assistant Treasury Secretary Michelle Davis. “We do not expect to need to execute on either [the increased Treasury lending or the government stock purchase] immediately.”

The government stopped short of an outright takeover of the two companies, which have suffered billions of dollars in losses as rising numbers of Americans default on their mortgages.

Nevertheless, the plan amounted to a blunt acknowledgment that what began as a stock-market sell-off by jittery investors had grown in intensity and begun to threaten the functioning of the mortgage market and health of the broader U.S. economy.

“It is very dramatic and historic,” said Ed Grebeck, chief executive of Tempus Advisors, a debt-strategy firm in Stamford, Conn. “The government must have felt it had no choice because of the situation in the residential property market combined with mortgage defaults of an unprecedented nature.”

The government’s plans are aimed at persuading Wall Street to renew its faith in the operations of Fannie Mae and Freddie Mac, to reassure holders of the companies’ bonds that the government stands behind the debt and to allow the firms not only to continue running but to expand operations so they can ease the grip of the credit crunch on the nation’s economy.

The plan calls on Congress to increase the companies’ existing $2.25-billion credit lines at Treasury and to allow the department to take the extremely rare step of buying equity stakes, if needed, to bolster the companies’ capital.

The plan also calls for tighter regulation of the mortgage giant by having the Federal Reserve play a role in overseeing them.

The 5-0 vote by the Fed’s Board of Governors to lend money directly to Fannie and Freddie marked the second time this year that the Fed had stepped in to help bolster the nation’s jittery financial system. In March, as Bear Stearns nearly failed, it allowed similar borrowing by investment banks.

Though publicly owned, Fannie and Freddie were chartered by the government and are relied on to grease the wheels of the housing market. They buy mortgages and mortgage-backed securities with money borrowed in the credit markets, and any sign that they can’t get access to funding could throw another monkey wrench into the troubled housing market.

Between them, Fannie and Freddie have about $90 billion in capital as a cushion against future loan losses. By contrast, the two companies lost a combined $11.8 billion in the nine months ended March 31.

But investors fear that U.S. home prices will continue to decline and that the losses on loans the companies either own or guarantee will get much worse over the next year, depleting their remaining capital.

The government took action early Sunday night in advance of a crucial debt sale by Freddie Mac scheduled for today. Originally viewed as a routine refunding of maturing debt, Freddie was expected to sell $3 billion of short-term notes in a litmus test of the two companies’ ability to raise cash for routine operations.

“That’ll pretty much tell you what the global markets think of Fannie and Freddie and the broader U.S. residential real estate situation,” Grebeck said. If debt investors demand that Freddie Mac pay significantly higher interest rates than usual compared with Treasury securities, “that’ll basically establish global-market skepticism.”

The plan is certain to be highly controversial, with critics saying it bails out shareholders of companies that took excessive risks during the housing boom in recent years.

Critics of government intervention say such rescues encourage irresponsible investing -- thus bringing about financial-market bubbles -- because investors believe the government will bail them out at taxpayer expense.

The so-called moral hazard became a big issue after the Fed-engineered rescue of Bear Stearns.

“If the government won’t let anybody fail, where’s the penalty?” said Kingman Penniman, head of KDP Investment Advisors Inc., a bond-research firm in Montpelier, Vt.

Paulson alluded to that issue, saying: “Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer.”

Nearly every government agency that has anything to do with the two companies, as well as the top executives of the firms themselves, issued statements Sunday night praising the Fed and the Treasury actions.

But there was at least one hint that trouble may be brewing on Capitol Hill as Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.) lambasted the White House’s performance in the current housing crisis.

“The administration’s failure to prevent bad lending practices has caused unprecedented hardship in the form of record foreclosures and market turmoil,” Dodd said. “Now, homeowners across the country and our entire financial system are suffering the consequences.”

Dodd’s remarks were a jarring counterpoint to those made by others involved in the weekend talks leading to the government actions.

Richard F. Syron, Freddie Mac’s chief executive, said he was “heartened” by the Federal Reserve and Treasury actions, saying they “should go a long way toward reassuring world markets that Freddie Mac and Fannie Mae will continue to support America’s homeowners.”

Similarly, Fannie Mae Chief Executive Daniel H. Mudd said he appreciated the “expressions of support” for his firm and looked forward to “swift passage of the new legislative proposals” advanced by Treasury.

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walter.hamilton@latimes.com

peter.gosselin@latimes.com

Hamilton reported from New York, Gosselin from Washington.

Times staff writers Tom Petruno and Maura Reynolds contributed to this report.