Fannie-Freddie bailout

In an extraordinary federal intervention, the Bush administration finally bit the bullet, and placed the crisis-ridden mortgage organizations, Fannie Mae and Freddie Mac, in a government conservatorship, much like a bankruptcy reorganization.

The bailout, which could become one of the most expensive financial bailouts in the US history, was justified by Treasury Secretary Hank Paulson as vital to restore stability in the financial markets, "This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation."

The plan also commits the government to provide as much as $100 billion to each company to backstop any shortfalls in capital. It enables the Treasury to ultimately buy the companies outright at little cost. It also eliminates dividend payments to current shareholders while protecting the principal and interest payments on the debt, now held by foreign central banks, financial institutions, pensions funds and others. Further, for the first time ever, the government plans to buy significant amounts of their mortgage-backed securities on the open market, beginning with the purchase of $5 billion worth this month.

For long, these two organizations which buy mortgages from commercial lenders (and sell most of it to investors as morgage backed securities and some held in the two companies portfolios), have dominated the federal mortgage finance market (both guarantee nearly 70% of all new home loans) by borrowing at low interest rates capitalizing on their implicit government guarantee. They have consistently faced criticisim from free-market enthusiasts for crowding out private financiers by leveraging advantages like maintainance of only a tiny sliver of capital to protect them from nasty surprises like the recent sharp decline in housing prices and rise in foreclosures.

Though the shareholders of the two giants are certain to take massive hits as the share prices continue to fall, many of the companies outgoing executives are likely to go out with handsome paychecks, despite the crisis their actions and leadership has spawned. The reasons for the crisis has been covered in an earlier post here.