Freddie sold $3 billion of two-year reference notes this week at 3.229 percent, or 97.5 basis points more than Treasuries of similar maturity, the highest since at least 1998, based on company and market data compiled by Bloomberg.





Fannie, Freddie Capital Concerns Prompt Paulson to Take Control

By Dawn Kopecki and Alison Vekshin

Sept. 7 (Bloomberg) -- Treasury Secretary Henry Paulson decided to take control of Fannie Mae and Freddie Mac after a review found the beleaguered mortgage-finance companies used accounting methods that inflated their capital, according to people with knowledge of the decision.

Morgan Stanley, hired by the Treasury to probe the companies' finances, concluded the accounting, while legal, enabled Freddie, and to a lesser extent Fannie, to overstate the value of their reserves, according to the people who declined to be identified because the findings are confidential.

The Treasury plans to put Fannie and Freddie into a so- called conservatorship and pump capital into the companies, House Financial Services Committee Chairman Barney Frank said in an interview yesterday. The government would make periodic capital injections by buying convertible preferred shares or warrants, according to a person briefed on the plan. Paulson is seeking to end a crisis of confidence in the companies sparked by concern the companies didn't have enough capital to weather the biggest housing slump since the Great Depression.

The Treasury was ``convinced that the markets simply wouldn't respond until after something like this,'' said Frank, who was brief by Paulson. ``I think it's an important combination.''

Paulson is likely to make the announcement today, according to people familiar with the decision. He gathered Federal Reserve Chairman Ben S. Bernanke, Federal Housing Finance Agency Director James Lockhart, Fannie Chief Executive Officer Daniel Mudd and Freddie CEO Richard Syron to discuss the plan to take control of the government-sponsored enterprises, which have operated as private shareholder-owned corporations for almost 40 years.

Debt Holders Protected

Holders of the companies' common and preferred stock are ``very unlikely to come out of this at all happy,'' and the chief executive officers will be forced out, Frank said. Senior and subordinated debt holders will likely be protected, said other people who were briefed on the plan.

Fannie and Freddie own or guarantee almost half of the $12 trillion in U.S. home loans and the government had been leaning on the companies to help pull the economy out of the housing crisis. Instead, they got caught in the same slump that left the world's banks with more than $500 billion of losses since the collapse of the subprime-mortgage market last year.

Rising Costs

Concern over the companies' capital pushed their borrowing costs to record levels over U.S. Treasuries, sent their common and preferred stocks tumbling and boosted mortgage rates. Washington-based Fannie is down about 66 percent in New York Stock Exchange trading since the end of June. McLean, Virginia- based Freddie has fallen about 69 percent.

Paulson met with Mudd, 50, and Syron, 64, Sept. 5 to tell them of the decision to remove the executives from their jobs, according to two people briefed on the discussions. Mudd, who replaced three top executives almost two weeks ago, is negotiating with regulators to stay on in a consultative role for several months, according to people with knowledge of the talks.

A government takeover would be the latest attempt to blunt the impact of the yearlong credit crisis, after the Fed provided financing for Bear Stearns Cos.'s takeover by JPMorgan Chase & Co.

``They have to open their wallet,'' Bill Gross, manager of the world's biggest bond fund at Newport Beach, California-based Pacific Investment Management Co. About 61 percent of Gross's holdings were mortgage-backed securities as of June 30, mostly debt guaranteed by Fannie, Freddie or government agency Ginnie Mae, according to data on Pimco's Web site.

Obama, McCain Briefed

Pimco and other large investors may put in their own money once the Treasury decides to inject government funds, Gross said Sept. 5 in a Bloomberg Television interview.

Paulson hired Morgan Stanley a month ago to advise on Fannie and Freddie. Mark Lake, a spokesman for Morgan Stanley, declined to comment. Paulson also consulted with Bank of America Corp. Chief Executive Officer Kenneth Lewis on his plan, according to people with knowledge of the talks. Bank of America spokesman Scott Silvestri declined to comment.

The Treasury briefed Democratic presidential candidate Barack Obama yesterday and has contacted Republican contender John McCain's staff. Officials also discussed the plans with House Speaker Nancy Pelosi, Senate Majority Leader Harry Reid and Senate Banking Committee Chairman Christopher Dodd.

``We are making progress on our work with Morgan Stanley, FHFA and the Fed,'' Treasury spokeswoman Brookly Mclaughlin said Sept. 5 in Washington, declining to comment on any specific plans. FHFA spokeswoman Stefanie Mullin declined to comment.

Losses Grow

Fannie was created by the government in 1938 as part of President Franklin D. Roosevelt's New Deal. Freddie was chartered in 1970 to compete with Fannie.

As losses on the mortgages grew late last year, the companies recorded $14.9 billion in combined net losses, eating into their capital. Fannie raised $14.4 billion since November and Freddie sold $6 billion of preferred securities. Plans for a $5.5 billion sale were delayed as the company's fortunes sank.

Fannie had $47 billion of capital as of June 30, according to company filings. The company is required by its regulator to hold $37.5 billion. Freddie's capital stood at $37.1 billion, compared with a requirement of $34.5 billion, filings show.

Critics including former Federal Reserve Chairman Alan Greenspan and Richmond Federal Reserve Bank President Jeffrey Lacker have called for the companies to be nationalized. William Poole, the former head of the St. Louis Fed said in July that Freddie Mac is technically insolvent and Fannie Mae's fair value may be negative next quarter.

Fed Involvement

Fannie and Freddie dropped in after-hours trading on Sept. 5. Fannie fell $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70. The market value of Fannie's $21.7 billion in preferreds had dropped 64 percent to $7.87 billion late last month, according to Friedman Billings & Ramsey & Co. The market value of Freddie's $14.1 billion in preferreds has fallen 61 percent to $5.44 billion.

Fannie's market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie's has fallen to $3.3 billion, from $22 billion over the same period.

Bernanke participated in the meetings because the central bank was given a consultative role in overseeing Fannie's and Freddie's capital under legislation approved in July. Paulson's decision won the approval of Bernanke and Lockhart, the person briefed on the discussions said.

Conservatorship

The FHFA has the authority to place Fannie or Freddie into conservatorships or receiverships under the law. The legislation that President George W. Bush signed July 30 also gave the Treasury the power through the end of next year to extend unlimited credit to or make equity purchases in the firms.

Under a conservatorship, the authorities would aim to preserve Fannie and Freddie assets, rather than dispose of them, the law says.

The FHFA was scheduled to release its assessment of the companies' capital levels as early as last week as part of a quarterly appraisal of their finances.

Analysts have speculated that the Treasury would wipe out common shareholders, while seeking to shield preferred stockowners from total loss. Fannie and Freddie preferred shares are typically owned by banks and insurance companies. Their $5.2 trillion of debt outstanding is held by investors including Asian central banks, and would probably be guaranteed, analysts said.

Frank said the federal government will take a senior repayment position to ``all shareholders, preferred and common.''

The Treasury is ``going beyond no dividends, I believe, in terms of what's going to happen to the shareholders,'' Frank said. ``I think shareholders are going to find themselves in a very subordinate position.''

Debt Markets

``Treasury's main concern is the debt markets, and if it was to say that it will do whatever is necessary to keep Fannie and Freddie running, the better it is for their funding,'' said Alex Pollock, fellow at the American Enterprise Institute in Washington and former president of the Chicago Federal Home Loan Bank.

Fannie and Freddie sell billions of dollars of bonds each month to pay maturing debt. As of mid-August the companies had $223 billion of debt to refinance by the end of the quarter.

While they have continued to issue securities, Fannie and Freddie have paid record yields over U.S. Treasuries to attract investors reluctant to take on the debt even with its implicit backing from the government.

Freddie sold $3 billion of two-year reference notes this week at 3.229 percent, or 97.5 basis points more than Treasuries of similar maturity, the highest since at least 1998, based on company and market data compiled by Bloomberg.

To contact the reporter on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net; Alison Vekshin in Washington at avekshin@bloomberg.net;

Last Updated: September 7, 2008 00:02 EDT

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