US Government steps in to bail out mortgage giants Fannie Mae and Freddie Mac

The effects of the Freddie Mac and Fannie Mae bail-out are likely to spread beyond the US in coming days, as investors contemplate the continued fragility of credit markets and the potential risks associated with mortgage lenders. The banking sector is likely to be hit particularly hard.

To protect the two organisations from insolvency, Treasury Secretary Hank Paulson announced they would have access to a bigger credit line for the next two years. He did not give details on the amount or of the terms. He said the Treasury Department would also seek temporary authority to buy shares in the companies if necessary. The measures require Congressional approval, which will be sought urgently. Separately, the Federal Reserve has voted to open a lending facility for Fannie Mae and Freddie Mac, if they need emergency capital. The companies would be able to use their own securities as collateral.

Compared with the latest crisis, the problems of Bear Stearns four months ago will look minor.

Freddie Mac and Fannie Mae are the grease in the US mortgage market. They hold or guarantee more than 50% of US mortgages. This is more than $US5 trillion ($A5.17trillion) in mortgages, or about five times the size of Australia's economy.

Their role in the US financial system is unique. Set up by the Federal Government 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, can 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 - which find the customers and sign them to loans. Freddie and Fannie then package the mortgages into securities, which are 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. Now there are real doubts.

In the face of their spiralling share prices, the market began to panic about the solvency of Freddie Mac and Fannie Mae.

As the subprime housing crisis has unfolded, and defaults have skyrocketed, the balance sheets of the two companies have come under increasing scrutiny as investors contemplated the lenders' exposure. Last week their shares plunged. Fannie Mae was off 45% for the week to barely a seventh of its 52-week high. Freddie Mac shares sank 47% to one-ninth of their 52-week high.

The two companies have lost $US100 billion in the past year.

Faced with those precipitous falls, US regulators decided not to risk letting the market decide the companies' fate this week.

Essentially the regulators are standing behind not only the loans but also the shares in these companies.

It would be tantamount to the Australian Government offering to buy shares in Commonwealth Bank or Westpac rather than letting them go under.

But it means that US taxpayers have, overnight, accepted an as yet unquantified liability. The White House issued a short statement exhorting Congress to pass any legislation needed to implement the bail-out 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," the statement 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," he said.

"Their support for the housing market is particularly important as we work through the current housing correction."

MALCOLM MAIDEN

Investors have time to gauge the success or otherwise of the weekend attempt by US regulators to erect another market Maginot line, in the form of funding support for Fannie May and Freddie Mac - institutions that by virtue of their funding of half of the US mortgage market are deemed too big to fail - but also, possibly, too big to save without denting the exchequer, and the economy.

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