Bailout is no simple matter

Times Staff Writer

When Treasury Secretary Henry M. Paulson Jr. reveals how the Bush administration intends to steady tottering mortgage giants Fannie Mae and Freddie Mac -- probably this afternoon -- he will be walking a knife edge between two seemingly irreconcilable views on what the government should do.

Free-market analysts and their allies in the Bush administration believe that the companies -- government-chartered but shareholder-owned -- pose a threat to Washington’s own solvency and must be thrown into a bankruptcylike receivership, run by the government until the current financial crisis eases and then broken up or sold off. In no case, say advocates of this view, should the Treasury Department pump taxpayer money into the once-rich enterprises, which hold more U.S. home mortgages than any other company and have seen their fortunes plummet with the housing market.

On the other side, congressional Democrats and major financial market players argue that the government should spare no expense in rescuing Fannie Mae and Freddie Mac. They argue that the mortgage giants must be healthy not only for Americans to buy houses, but for the economy to regain its footing.


This faction argues that the government should exercise its stewardship with a lighter hand, stopping short of pushing Fannie and Freddie into anything like bankruptcy. And Washington should pump the two institutions up with tens of billions of taxpayer dollars, they say.

Paulson is expected to announce his plan this afternoon. On Saturday, his aides were quietly spreading word that he was hoping to find a middle ground between these two extremes by establishing the government as the “conservator” of the companies -- a less draconian step than forcing the companies into full-blown receivership, according to senior figures on Capitol Hill.

But that doesn’t mean the Treasury secretary has agreed to a big injection of taxpayer money or has settled on what will happen to the firms and their stockholders, the officials say.

“This has no impact one way or the other on what the ultimate shape of the institutions is,” said House Financial Services Committee Chairman Barney Frank (D-Mass.), who has been in regular contact with Paulson and his aides. “A conservatorship will let [Fannie and Freddie] finally focus on their housing mission. It won’t be good for shareholders, but it will be good for housing.”

The question is whether such a middle course will prove tenable. If Paulson’s proposal is received favorably, it could steady the housing and financial markets and give the economy some breathing room. That in turn could help both home buyers and sellers by pushing down mortgage rates and making credit more easily available.

Peter J. Wallison, a Treasury official under President Reagan and perhaps Fannie and Freddie’s sharpest critic, has warned that the companies have grown so large that they represent a threatening liability for the government -- one it should try to shed as soon as responsibly possible.


“If there’s an injection of capital, that means Treasury will prop up Fannie and Freddie, they’ll survive in pretty much their current form and the taxpayers will suffer,” said Wallison, an analyst with the conservative American Enterprise Institute.

Taxpayers could suffer most immediately if the housing crisis worsens, the mortgage giants’ fortunes deteriorate and the federal investment vaporizes in the process.

Bill Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co. (better known as Pimco) in Newport Beach, disagrees. He wants Fannie and Freddie to get huge infusions of federal cash.

“We want to see the money,” Gross said. “If Paulson comes out with a few billion dollars, that’s nice, but it doesn’t do the job. It doesn’t speak to Fannie and Freddie being able to keep making mortgages and helping the economy recover.”

Between them, Fannie and Freddie own or guarantee more than $5 trillion of U.S. home mortgages, or about half the total outstanding. The mortgage-backed securities that they manufacture have been sold by thousands of banks and investors in the U.S. and around the world.

The two firms have suffered about $14 billion in losses during the last year and could face tremendous additional losses amid a continuing slump in housing prices and the worst bout of home foreclosures since the Great Depression.


In July, the nonpartisan Congressional Budget Office estimated that a government bailout of the pair could cost taxpayers about $25 billion over 10 years. Congress’ number-crunching arm also warned that huge uncertainties would surround any bailout. It guessed that the chance was better than even that Washington wouldn’t need to spend anything on the firms -- but a 5% chance it would have to pay out more than $100 billion to cover as-yet-unrecognized losses.

With Paulson now ready to seize the firms, chances of a no-cost outcome appear to have dimmed and those of a high-cost result to have increased considerably.

The pending federal action on Fannie and Freddie caught the attention of the presidential tickets Saturday.

At a rally in Colorado Springs, Colo., Republican vice presidential nominee Sarah Palin, Alaska’s governor, said of Fannie and Freddie: “They’ve gotten too big and too expensive to the taxpayers. The McCain-Palin administration will make them smaller and smarter and more effective for homeowners who need help.”

Democratic presidential nominee Barack Obama blasted the Bush administration as having failed to heed warnings that the companies were faltering.

“We have to make clear that in our market system, investors can’t be allowed to believe that, unlike working families, they can simply invest in a heads-they-win, tails-they-don’t situation,” the Illinois senator told reporters while campaigning in Indiana.


He said that some of the companies’ problems resulted not from the housing market plunge but from executives’ irresponsibility.

“Management was not making decisions that were designed to help them meet what should have been the mission, which is simply to provide liquidity in the housing market,” he said. “They were boosting profits as a priority, with the management bonuses that came with those profits.”

Paulson and the Federal Housing Finance Agency -- Fannie and Freddie’s newly created regulator -- are expected to use legal powers granted by Congress in July to put the firms under conservatorship.

The powers allow the agency to run the companies indefinitely under some circumstances. But Rep. Frank said in an interview that Paulson had told him the agency would probably control the firms for about a year while lawmakers and the next administration debated whether the two operations should remain part of the government or be privatized.

As part of the government’s assumption of control, the chief executives of Fannie and Freddie -- Daniel Mudd and Richard Syron, respectively -- would step down from their positions, though they might not immediately leave the firms.

Paulson and Federal Housing Finance Agency Director James Lockhart are to appoint conservators to run the companies and try to restore their financial health.


Frank said decisions might not be immediate on how much taxpayer money, if any, would be injected into the firms. But he said that if the government did put money in, it would be first in line -- ahead of the companies’ shareholders -- to be repaid.

“This is not a bailout, particularly for the shareholders,” Frank said. “This will not be pouring money into the existing entities.”

Until this summer, it was assumed but not known that the government stood behind the companies and would rescue them in case of trouble.

That gave the pair a huge leg up on conventional financial firms: They could borrow at nearly the same low interest rates as Washington, and their stock and securities were treated as almost as much of a sure thing as the federal government’s continued functioning.

But after more than a year of falling house prices and a subprime mortgage debacle that rattled confidence in the mortgage market generally, investors began to wonder whether Fannie and Freddie were really so secure and whether Washington would make good on its implicit guarantee of their finances.

For months, Paulson sought to talk investors out of their doubts. When that didn’t work, he won congressional approval in July to lend the firms virtually unlimited amounts and even to purchase their stock.


Paulson insisted that the simple fact of such Treasury authority would calm investors, and he repeatedly said he didn’t expect to use the powers.

“If you’ve got a bazooka and people know you’ve got it, you may not have to take it out,” he told one congressional panel.

But according to Gross of Pimco, investors continued to have doubts about whether Washington really was ready to support the firms financially.

“The market recognized the bazooka had all of the earmarks of a bluff,” he said. “Unless it was loaded with money and wasn’t a popgun, it didn’t mean very much.”

Gross said that for Paulson’s rescue plan to be taken seriously, Treasury must pump $10 billion to $15 billion into each company, immediately or over time. Without such a commitment, he said, investors will be reluctant to follow suit with other troubled firms that are more conventional.

“Banks are in desperate need of money, and Paulson wants private investors to inject capital into the banks,” he said. “One way to get them to do that is for Paulson to inject money into these government-sponsored companies.


“We’re looking for the numbers. We want to see how big they are.”


Times staff writers Noam N. Levey in Indiana and Maeve Reston in Colorado contributed to this report.