How we got to this place…..

by Tom Vanderwell

Mortgage Officer

Author website

I promise I won’t take up so much space on here after the dust settles, but I’m having a hard time getting my mind around the enormity of what’s happening with Fannie and Freddie and what it means, so I figure the best thing I can do is share what I know with others……

I came across this article in the Wall Street Journal which lays out a good “story” of what has transpired.   I’m going to copy excerpts of it, but I’d urge you to read the whole thing…….

WASHINGTON — In the end, Fannie Mae and Freddie Mac had no choice.

Summoned to separate meetings on Sept. 5 with Treasury Secretary Henry Paulson and other top officials, the two mortgage giants were told they could either agree to a government takeover or one would be foisted upon them.

“We have the grounds to do this on an involuntary basis, and we will go that course if needed,” Mr. Paulson told senior executives at the two companies, who had little idea such a move was coming, according to three people familiar with the meetings.

There was no dramatic trigger, nor was there fear of imminent collapse. Instead, the sweeping government intervention stemmed from a growing realization by Treasury and Federal Reserve officials that the two companies couldn’t survive in their present forms, and that any collapse would be devastating to the economy.

The decision was hashed out over weeks of meetings…….

In the end, Mr. Paulson, Federal Reserve Chairman Ben Bernanke and James Lockhart, head of the companies’ regulator, the Federal Housing Finance Agency, concluded that the two companies had lost the confidence of the markets and couldn’t survive as currently structured. …..

Inside Treasury, the hope was that merely receiving authority to backstop the two companies would comfort markets enough that they could raise capital on their own. ……..

Two things would soon force Treasury’s hand. Uncertainty about Treasury’s plans and how any intervention would affect shareholders caused shares of Fannie and Freddie to fall sharply, making it all but impossible for them to raise equity. At the same time, government bank supervisors and Morgan Stanley bankers studying the loans that are guaranteed and owned by Fannie and Freddie determined that the companies were facing serious capital shortfalls…….

Inside Treasury, the working theory was that if they had to intervene, an equity investment would be the most likely course. Mr. Paulson and his staff debated the impact on shareholders, discussing whether to structure an investment that would benefit stockholders or one that would dilute them. If they made an investment, Mr. Paulson told his staff, he did not want it to benefit shareholders……..

Financial institutions, investors and other market participants were painting a grim picture: Investors weren’t going to invest more in the company unless Treasury kicked in some money, or made clear what would happen to those who did pony up funds.

Treasury asked how much money they’d need to inject. It soon became clear that no amount was going to be enough. If Treasury were to inject $10 billion, the market would want to see $20 billion. If Treasury put forth $20 billion, the market would want $30 billion.

At Fannie Mae and Freddie Mac, executives were painting a much rosier picture. They insisted they could raise capital if Treasury would step in and provide some kind of support. Fannie Mae proposed that the government guarantee that new investors would be protected if the government later intervened — a move Fannie thought would help it raise money…….

The upshot: The companies were facing a deep financial hole. While their capital might meet the letter of regulatory requirements, they still might not have enough to cover their expected losses…..

Using assessments about what would happen to the housing market over the next 18 months, they determined that the companies were in need of much as $50 billion…….

At that point, Mr. Paulson and his staff began to realize an equity investment might not work. The companies needed so much capital that if Treasury were to go in, it would have to either wipe out shareholders or structure the investment on generous terms.

Morgan Stanley presented three options to Treasury: receivership; a less aggressive option called conservatorship, in which the government would essentially run the companies’ operations; and the even more incremental step of having the companies try to raise money on their own.

Fannie and Freddie were still able to fund themselves, but it was getting more expensive to do so. Foreign officials, whose central banks own Fannie and Freddie debt, were calling Mr. Paulson to express concern.

Sen. Charles Schumer, a New York Democrat, said he was told by government officials that foreign investors were threatening to bail out. “There was a real fear that foreign governments would start dumping Fannie and Freddie…and not buy the bonds,” he said……..

The big decision came together during a marathon series of meetings over Labor Day weekend at Treasury’s offices. A dozen Treasury officials, including Mr. Paulson, gathered together with Mr. Bernanke, Fed Governor Kevin Warsh, the Fed general counsel and a top banking official and Mr. Lockhart’s team.

The group gathered in a conference room across from Mr. Paulson’s office at 8:30 a.m. that Saturday. They were dressed mostly in business-casual khakis and shirts. They began discussing their overarching principles, and evaluating the pros and cons of each option.

They recognized they only had bad alternatives, but agreed that the risks of doing nothing were too great. By late Saturday, they were leaning toward conservatorship as the best option. They spent the next two days thinking through legal and market implications. Mr. Paulson led the sessions. Mr. Bernanke and other top officials weighed in.

Treasury planned to tell the two companies about the plan last Friday, and complete it by Sunday, in time for the opening of Asian markets. Mr. Paulson needed one more thing: He pressed for Mr. Bernanke to issue a statement of support.

Mr. Lockhart, however, wanted more analysis. Without his approval, the takeover would not happen. After looking at data assembled by the Fed, the Office of Comptroller of the Currency and FHFA, Mr. Lockhart agreed that the companies were in a severe capital hole.

On Friday, Mr. Mudd, Fannie’s CEO, and Richard Syron, the Freddie Mac’s chief executive, were summoned to FHFA’s offices in Washington for separate meetings. Messrs. Lockhart, Paulson and Bernanke sat on one side of the conference room table. Company executives sat on the other side.

Mr. Lockhart spoke first, telling the firms that they were going be taken over. Mr. Paulson then told the executives they could go along willingly, or FHFA would declare them undercapitalized and take them over involuntarily…….

“Paulson said, ‘Accept or it will happen,’ ” Mr. Syron told the board, according to a person familiar with the matter.