Paulson Says Fannie, Freddie Crisis `All Consuming'

By Rebecca Christie and Peter Cook

Sept. 8 (Bloomberg) -- Treasury Secretary Henry Paulson said the discussions over how to prop up Fannie Mae and Freddie Mac were ``all consuming'' in recent weeks, when he was forced to make a decision he would rather have avoided.

``This is the first time in my career I had trouble sleeping, and it wasn't because it was a difficult decision,'' Paulson said in interview with Bloomberg television. Paulson, 62, took the Treasury's helm in 2006 after a 32-year career at Goldman Sachs Group Inc.

As financial markets deteriorated, resembling the situation in March when Bear Stearns Cos. collapsed, foreign central banks began expressing concerns about Fannie and Freddie, the mortgage companies whose debt they hold. Paulson said that while he preferred not to oversee a government takeover, in the end there was no choice.

``Government intervention is not something that I came here wanting to espouse, but it sure is better than the alternative,'' the Treasury chief said. He spoke a day after the Treasury and Federal Housing Finance Agency put the companies into conservatorship, providing for up to $100 billion of equity investments by the Treasury in each to keep them solvent.

Foreign central banks had concerns about the two companies, in part because of their size, Paulson said. Fannie and Freddie make up almost half of the $12 trillion U.S. mortgage market. U.S. investors also wanted to know what they were facing, he said.

Stocks, Bonds

Fannie fell 79 percent to $1.46 and Freddie lost 71 percent to $1.50 as of 9:53 a.m. in New York Stock Exchange trading. Credit Suisse analysts cut their price target on the companies to $1. At the same time, the companies' bonds rallied.

The rescue won backing from the world's major central banks, including those in Asia where much of the mortgage companies' debt is held.

``This is positive,'' People's Bank of China Governor Zhou Xiaochuan told reporters today in Basel, Switzerland, at a meeting at the Bank for International Settlements. Bank of Japan Governor Masaaki Shirakawa said he expects the takeover to ``stabilize'' U.S. and global financial markets.

Paulson said the current management and boards of the two companies aren't to blame for the firms' situation. They had a ``flawed'' business model with a federal charter and shareholder ownership, and suffered from the rout in the U.S. mortgage market, he said.

No `Happy Time'

The episode has ``not been a happy time for anyone,'' Paulson said. ``I've never been through any situation which was as difficult, as stressful, as complex.''

The Treasury chief reiterated that yesterday's intervention is a ``time-out'' that leaves it to the next Congress and administration to decide on Fannie's and Freddie's long-term structure.

Yesterday's action leaves open the option favored by former Federal Reserve Chairman Alan Greenspan, to split up and sell off the companies, or a full nationalization that would cement the government's role in mortgage markets. Avoiding a decision on the issue enhances the likelihood of congressional backing for the emergency steps, Democratic Senator Charles Schumer of New York said.

Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, warned against any attempt to dismantle Fannie and Freddie.

`Real Problem'

``This will be a real problem'' if the takeover was ideologically driven Dodd said. The Fannie-Freddie model has allowed the U.S. to be the ``only country'' where homeowners are able to get 30-year fixed-rate mortgages, he said.

The FHFA, which will run the conservatorship, ejected Fannie CEO Daniel Mudd, 50, and Freddie CEO Richard Syron, 64. They were replaced by Herbert Allison, 65, former CEO of TIAA- Cref, and David Moffett, 56, who was a US Bancorp vice chairman.

The Treasury also said yesterday it will provide secured short-term funding to Fannie, Freddie and 12 federal home-loan banks, and purchase mortgage-backed debt in the open market. The New York Federal Reserve Bank will act as the Treasury's agent for the lending facility.

``This is not a permanent solution -- they've not saved Fannie and Freddie, what they've done is they've bought 15 months,'' said Bill Ackman, founder of Pershing Square Capital Management in New York, which has sold short the two companies, or bet on declines in their securities. ``It's a band-aid. They haven't permanently recapitalized the companies.''

Bond Rally

Yields on Fannie Mae and Freddie Mac debt relative to Treasuries tumbled by the most on record on rising confidence in their creditworthiness after the government takeover.

The difference between yields on Fannie's five-year debt and five-year Treasuries fell 29.1 basis points to 64.9 basis points as of 8 a.m. in New York, the lowest since May, according to data complied by Bloomberg. The yield fell to 22.1 basis points below interest-rate swaps, another benchmark, the lowest since February and down from 4.8 basis points.

The takeovers bring Fannie, formed after the Great Depression and spun off in 1968, and Freddie, created in 1970, back under the government's fold. It's the biggest step yet in officials' efforts to grapple with a yearlong credit crisis that has caused more than $500 billion of losses and writedowns.

Under the plan, the Treasury will receive $1 billion of senior preferred stock in coming days, with warrants representing ownership stakes of 79.9 percent of Fannie and Freddie. The government will receive annual interest of 10 percent on its stake.

Portfolio Limits

As a condition for the assistance, Fannie and Freddie eventually will have to reduce their holdings of mortgages and securities backed by home loans.

While common stockholders of Fannie and Freddie won't be eliminated, they will be last in line for any claims, Paulson said. Preferred shareholders will be second in absorbing losses, he said. Interest and principal payments will continue to be made on the companies' subordinated debt, Lockhart said.

The government is taking an increasing role in financial markets, after the Fed six months ago provided $29 billion of financing to prevent the collapse of Bear Stearns Cos. Chairman Ben S. Bernanke praised yesterday's action.

Democratic presidential nominee Barack Obama said yesterday that ``some'' intervention was necessary to prevent a ``larger and deeper crisis.'' After the current crisis subsides, ``the plan must move toward clarifying the true public and private status of our housing policies,'' he said.

`Downward Spiral'

``We've got to keep people in their homes,'' Republican presidential candidate John McCain said in an interview with CBS's ``Face the Nation'' program. ``There's got to be restructuring, there's got to be reorganization, and there's got to be some confidence that we've stopped this downward spiral.''

The government takeover comes almost two months after Paulson first sought emergency powers to inject capital into the beleaguered mortgage-finance companies. Congress approved the measure in legislation signed by President George W. Bush on July 30.

Paulson had indicated until early last month that it was unlikely he'd use the authority, and then kept silent even as investors clamored for clarity on how a government intervention would work.

``There are an enormous number of decisions ahead and they will be very controversial and there will be a lot of conflict,'' William Poole, former president of the Federal Reserve Bank of St. Louis, said in a Bloomberg Television interview. ``We don't know what the ultimate cost is. If they lose 5 percent on all their obligations, that doesn't seem like an outrageous amount to lose. That's right away $300 billion.''

MBS Purchases

Included in yesterday's measures is a Treasury program to purchase new mortgage-backed securities from the two companies, starting with a $5 billion purchase this month.

The Treasury will also hire independent asset managers to purchase and run the portfolio of mortgage-backed securities it will buy. ``There is no reason to expect taxpayer losses from this program, and it could produce gains,'' the department said.

Paulson's decision, taken after consulting with Bernanke, followed a review that found Washington-based Fannie and McLean, Virginia-based Freddie used accounting methods that inflated their capital, according to people with knowledge of the decision.

Morgan Stanley Role

Paulson hired Morgan Stanley a month ago to probe the companies' finances. The investment bank concluded that the accounting, while legal, enabled Freddie, and to a lesser extent Fannie, to overstate the value of their reserves, according to the people who declined to be identified because the findings were confidential.

Fannie and Freddie own or guarantee almost half of the $12 trillion in U.S. home loans and the government had been leaning on the companies to help pull the economy out of the housing crisis.

Concern over the companies' capital pushed their borrowing costs to record levels over U.S. Treasuries, sent their common and preferred stocks tumbling and boosted mortgage rates. Fannie is down about 93 percent in New York Stock Exchange trading since the end of June. Freddie has fallen about 92 percent.

To contact the reporter on this story: Rebecca Christie in Washington at Rchristie4@bloomberg.net;