Bailout plan for two giant US lenders

TO AVERT a second crisis of confidence in US credit markets, the United States Government has stepped in to prop up the two mortgage giants, Fannie Mae and Freddie Mac, before the markets opened again yesterday

TO AVERT a second crisis of confidence in US credit markets, the United States Government has stepped in to prop up the two mortgage giants, Fannie Mae and Freddie Mac, before the markets opened again yesterday

To protect them from liquidity problems, the Treasury Secretary, Henry Paulson, announced the two organisations would have access to a bigger credit line for the next two years. He did not give details on the amount of the credit line or terms.

The Treasury Department would also seek temporary authority to buy shares in the two companies should that be necessary, Mr Paulson said. The measures require Congress's approval, which will be sought as a matter of urgency.

Separately, the US Federal Reserve voted on Sunday to also open a lending facility for Federal National Mortgage Association (known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) if they need emergency capital. The two companies would be able to use their own securities as collateral.

Compared with the latest crisis, the problems of Bear Stearns four months ago, resolved by a buyout by JPMorgan and assisted by the Federal Reserve, will look minor.

Freddie Mac and Fannie Mae are the grease in the US mortgage market. They hold or guarantee more than 50 per cent of US mortgages: more than $US5 trillion ($5.17 trillion) in mortgages, or roughly five times the size of the Australian economy.

Their role in the US financial system is unique. Set up by the government of Franklin Roosevelt after the Great Depression of the 1930s to increase liquidity and make housing more affordable, they are seen as having an implied government guarantee, and this has been central to their business model.

Because of the guarantee, Freddie and Fannie, both listed on the stock exchange, are able to borrow money on the bond market more cheaply than any other mortgage originator. They then make the funds available to mortgage brokers and other retail banks - who find the customers and sign them up to loans.

Freddie and Fannie then take the mortgages and package them into securities which are then sold to superannuation funds and other investors. Because of the government guarantee, they were seen as a safe and secure investment, and are held by many Australian superannuation funds and banks - as were the two companies' shares.

But now there are real doubts.

In the face of their plummeting stock prices, the market began to panic about the solvency of Freddie Mac and Fannie Mae last Friday.

As the subprime housing crisis has unfolded, and defaults have soared, the balance sheets of the two companies have come under increasing scrutiny as investors have contemplated the two lenders' exposure.

Last week their shares plunged. Fannie Mae was off 45 per cent for the week to barely a seventh of its 52-week high, and Freddie Mac shares sank 47 per cent to one-ninth of their 52-week high.The two companies have lost $US100 billion in the past year.

Faced with those precipitous declines, the US regulators decided not to take the risk of letting the market decide the companies' fates this week.

Essentially they are now standing behind not only the loans but the shares in these companies. It would be tantamount to the Australian Government offering to buy shares in the Commonwealth Bank or Westpac, rather than let them go under.

But it means that the US taxpayer has, overnight, accepted an as yet unquantified liability.

The White House issued a short statement exhorting Congress to pass any legislation needed to implement the bailout plan. "It is crucial that Congress quickly works to enact this legislation as a complete package along with the strong oversight reform legislation recently passed in the Senate," it said.

Mr Paulson put it more bluntly: "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. Their support for the housing market is particularly important as we work through the current housing correction."

The latest developments are likely to spill quickly into the US presidential election campaign.

The Democratic nominee, Barack Obama, described the situation in the housing finance system as serious.

Mr Obama said a steady flow of capital to housing markets must be ensured, and "any measures should protect taxpayers and not bail out the shareholders and management of Fannie Mae and Freddie Mac".

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