Real Estate News Blog: Paulson Drove Rescue Plan

WASHINGTON -- Treasury Secretary Henry Paulson took the lead in crafting a rescue plan for ailing mortgage giants Fannie Mae and Freddie Mac, a move that appears to have staved off an imminent crisis but one that draws the federal government into an ever bigger role managing the American economy.

Mr. Paulson ordered his staffers to draw up contingency plans at the end of June, almost two weeks before such a move became public Sunday. He quickly persuaded the Federal Reserve to participate. As recently as a Friday breakfast between Mr. Paulson and Federal Reserve Chairman Ben Bernanke, such a move had been only briefly discussed.

On Monday, Freddie Mac passed a crucial test of investor confidence when its auction of short-term debt met with strong demand. Its offering drew more bids than usual, enabling the company to sell three-month and six-month notes at lower-than-expected yields and keep its borrowing costs low.

The offering helped calm fears over whether the mortgage companies could continue to finance their operations, but it did little to solve their long-term problem, which is that many investors believe they will have to raise large amounts of additional capital to absorb losses. The stocks of the two companies slipped again Monday, after being shelled last week.

'Far From a Panacea'

In a conference call, Gregory Peters, head of credit strategy at Morgan Stanley, said the government's action is "a positive for the housing market, but it's far from a panacea." The Treasury is asking Congress to approve an increase in Fannie Mae's and Freddie Mac's lines of credit with the Treasury, and for authority for the government to purchase equity in the companies. The Fed separately authorized direct lending to the two firms if necessary, a step that doesn't need lawmakers' approval.

In a letter sent Monday to the Fed and the Federal Reserve Bank of New York, Mr. Paulson said any lending by the Fed to the mortgage buyers would be an "interim step designed to serve as a bridge" until legislation is passed giving Treasury the authority it seeks.

The move, giving both companies the potential financial backing of the Treasury and the Fed, is the latest step by Mr. Paulson to use the government's power to stem housing-crisis fallout. A Republican and free-market advocate, he has become an activist in the mold of Clinton Treasury Secretaries Lawrence Summers and Robert Rubin. Mr. Paulson has orchestrated an agreement among banks to back shaky mortgage securities, cajoled the mortgage industry to help those in danger of foreclosure and pushed hard for the deal that culminated with the sale of collapsing Bear Stearns Cos. to J.P. Morgan Chase & Co.

In many ways Mr. Paulson's hand has been forced by circumstances as the housing crisis has spread into the broader economy. At the same time, the ad hoc moves have pushed the government into the unfamiliar position of backing big chunks of what used to be privately held debt, from student loans to mortgages to investment-bank assets. Merrill Lynch & Co.'s economists, in a research report Monday, described the move as more evidence the U.S. is steadily embracing the "Swedish model": directly intervening to solve economic ills. As the banking and finance sector continues to struggle, many assume more such moves are likely.

The amount of money at stake is hard to estimate but could be enormous. One element of the plan could raise Fannie Mae's and Freddie Mac's lines of credit with Treasury from $2.25 billion each to an unspecified level to be determined by the government later, according to people who have seen a draft of the plan. The draft language includes no upper limit.

The stocks of Fannie Mae and Freddie Mac extended their losses Monday as it became clear that while regulators will do what it takes to preserve their debt-paying ability, shareholders could still be hurt. Freddie Mac, which is seen as having a greater need to raise capital, lost 64 cents a share, or 8.3%, to $7.11 a share. Fannie Mae's stock fell 52 cents a share, or 5%, to $9.73. Fannie Mae shares have fallen 45% in the past four trading sessions, and Freddie Mac's 47%.

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The two are the dominant providers of funding for mortgage lending. They buy loans, keeping some but packaging most into securities for sale to investors all over the world. Together, they own or guarantee about $5.2 trillion of U.S. home mortgages -- nearly half of all those outstanding -- making them critical to the functioning of the housing market.

The seeds of Sunday's action began in late June as the mortgage buyers' stocks continued a steep decline. On June 30, Fannie Mae and Freddie Mac lost 6.2% and 8.1%, respectively.

Mr. Paulson was alarmed. He and others in the administration had long worried that the companies had grown too large and powerful and didn't have a strong-enough regulator to mitigate the risks they posed. In December, he had publicly and privately pressed them to raise more capital to bolster their cushion against losses and reassure markets.

Now, with their stocks tumbling, Mr. Paulson told his staff to start firming up ideas for what the government could do, if necessary, to bolster the two. Among the questions: What were the government's options and what would the market reaction be?

His staff worked to flesh out their ideas, which included a possible increase in their longstanding lines of credit with the Treasury. There was little expectation the Treasury would need to announce such steps anytime soon.

That began to change as the stocks continued to slide.

"A little more than a week ago [Mr. Paulson] began having conversations with us, multiple times a day, to think through what steps we had thought of with regard to preparedness and what steps we need to take," says Anthony Ryan, Treasury's acting undersecretary.

Shares Under Pressure

On July 10, a report in The Wall Street Journal about government contingency plans, followed by other news reports, left the companies' shares under further pressure. Investors assumed that any plan to raise more capital through new equity, either privately or through government funding, would dilute their holdings.

By Friday, July 11, the companies had lost more than 40% of their value in a week. With the Freddie Mac debt auction looming for Monday, Treasury officials were concerned about whether enough investors would want to buy the company's debt.

It had become clear by the middle of last week that the government might need to take steps to bolster the entities as media reports began to "shake the confidence in the markets," Mr. Ryan says.

That presented a quandary. Backing Fannie and Freddie would undermine a basic tenet of the free market: Investors should suffer for their mistakes. But as with Bear Stearns, Treasury thought the risk of not supporting the companies was far greater, say people familiar with its thinking. Without Fannie Mae and Freddie Mac out there buying loans, the stuttering mortgage market would seize up. Foreign central banks, many of which hold the companies' debt, would be affected. Wall Street could panic.

At the Federal Reserve, officials had long seen the mortgage giants as a concern -- Mr. Bernanke last year called their giant portfolios "a potentially significant source of systemic risk." But this wasn't the degree of trouble officials there had in mind. They weren't involved in the Treasury's key contingency-planning discussions and weren't bracing for the kind of market-destabilizing events they had worried about when Bear Stearns tumbled in March.

In such a tense environment, rumors ran wild: "The Fed is going to lend to Fannie and Freddie!" "The government is going to nationalize them!"

Friday morning, Mr. Paulson and Mr. Bernanke met for their usual weekly breakfast. The working relationship between the two is close, cemented during their response to the housing and credit crises. Sitting down for a 45-minute meal at Treasury, they caught the latest market news. They began discussing the full spectrum of options, from doing nothing to making government outlays.

Mr. Paulson began canvassing Wall Street, calling investment banks and other financial institutions to determine the level of nervousness. Reaction was mixed. Some institutions were nervous.

Expression of Confidence

Fannie Mae was also urging the Treasury to provide an expression of confidence in its operations. It wanted the Treasury to stamp out talk of nationalization and affirm that the companies should remain owned by private-sector shareholders. The Treasury released such a statement Friday morning, but it failed to calm investors.

Treasury officials settled on a potential increase in the line of credit and the possibility of an equity investment by the government as the best way to reassure markets. Since both options would require congressional approval, Mr. Paulson on Friday began reaching out to members of Congress.

House Financial Services Committee Chairman Barney Frank spoke with him on Friday. Mr. Paulson "thought the market was overreacting," Mr. Frank says.

Fannie and Freddie shares tumbled Friday afternoon, pulling down the rest of the stock market. That afternoon, a wire-service report said -- incorrectly -- that Freddie Mac Chief Executive Richard Syron had received a pledge from Mr. Bernanke by phone the prior day that Freddie Mac could tap the central bank's lending facility. The report caused a sharp turnaround in the two companies' stocks and in the broader market.

Mr. Syron called Mr. Bernanke that afternoon to apologize and say he wasn't responsible for the false report, according to a person familiar with the matter. His call with the Fed chief the prior day had been brief, lasting just minutes, with no mention of the lending facility or any other central bank plans. A Fed spokeswoman publicly denied the wire story after the market closed.

Mr. Paulson and other Treasury officials continued working into Friday night. At a conference call at 10 a.m. Saturday, senior officials from Treasury, the Fed and Securities and Exchange Commission reviewed the state of markets and possible options. Treasury officials hoped the Fed would be willing to provide a backstop to their plan.

On Saturday evening, Mr. Paulson hosted a call, telling Treasury staff that he was going to phone the heads of Fannie Mae and Freddie Mac that night and present them with details of the plan. The CEOs would have until noon on Sunday to come back with their thoughts.

According to people familiar with the matter, officials of Fannie Mae were encouraged that the Treasury had a broad plan that appeared to get ahead of the crisis, rather than just "a slow turning of the ratchet."

Rep. Frank says he spoke to Freddie Mac's Mr. Syron over the weekend, and "his impression was the company was much more solid than the market" was showing.

Mr. Bernanke, in his Fed office throughout the weekend, started calling the other four Fed governors Saturday evening to update them. Once Treasury made it clear there was a plan, the Fed decided it could offer Fannie Mae and Freddie Mac access to its lending facility, known as the discount window, but purely as a backstop. It was a move that could happen right away without congressional approval. The Fed's board of governors met at 1 p.m. Sunday and unanimously voted yes.

With the plan made final, Mr. Paulson worried about media leaks and the impact any erroneous information could have on the markets and the debt auction. He decided to announce the steps Sunday afternoon, ahead of the Asian financial markets opening.

At 6 p.m. Sunday the Fed issued a short, three-sentence statement. Mr. Paulson read his statement to cameras from the steps of the Treasury Department.