Treasury Department Announces GSE Conservatorship

Unless you spent Sunday spelunking in Howe's Cavern, you probably know that at about 11 a.m. the other shoe finally dropped. After weeks of anticipation and speculation, Treasury Secretary Henry Paulson announced that the federal government had taken over Freddie Mac and Fannie Mae.

Most of the day both before and after the seizure was announced television and Internet news sites were filled with comments and reactions from business writers, financial analysts, and presidential and vice presidential candidates. The general theme was that the takeover had to be done; that the two corporations were in critical condition and would probably continue to decline thus increasing the ultimate rescue costs; and that they were "too big to fail." There were, however, a lot of experts who questioned the method and scope of the action.

No one is really sure what the takeover will cost – estimates range as high as $200 billion – but it is clear that taxpayers and some stockholders are going to take a bath. It is also questionable just how much the drastic federal move will impact the housing slump, foreclosures, interest rates, or lots of other things that were given as reasons for the action.

Here is what we do know.

• The two mortgage giants are now operating in a government conservatorship that will be administered by the new Federal Housing Finance Agency (created under the same Congressional authority that authorized the Treasury Department to shore up Freddie and Fannie. James Lockhart, former director of the Office of Federal Housing Enterprise Oversight which had responsibility for the two government sponsored entities (GSEs) is the new director of the Finance Agency.
• The Conservator will control and direct the operation of the Company and will have all the powers formerly held by the shareholders, directors, and the officers of the Company and conduct all business, collect all money due to the company, preserve the assets and property of the company, and contract for any assistance necessary.
• In return for providing funds to guarantee their debt the Treasury Department will immediately receive $2 billion in preferred stock that will pay a 10 percent dividend. $1 billion of the stock will come from each of the two companies and the Conservatorship will purchase additional stock, perhaps as much as $100 billion worth, if the GSE's capital reserves fall below an agreed upon level. This preferred stock will take president over any claims by holders of common or the existing preferred stock.
• According to Secretary Paulson, the GSEs will modestly increase their mortgage backed securities portfolios through the end of next year "through prudent mortgage purchases" and will then reduce those holdings by 10 percent per year after 2009. The portfolios shall not exceed $850 billion for each company. An Associated Press article quoted Mark Zandi, chief economist for Moody's Economy.com, as saying this will effectively make the federal government the nation's mortgage lender.
• It appears that Treasury is primarily interested in protecting holders of GSE debt. This class of creditors includes many large investment companies and a number of foreign governments.
• The Treasury Department is establishing a new secured lending credit facility which will be available to the two GSEs and to Federal Home Loan banks.
• Both CEOs – Fannie's Daniel Mudd and Freddie's Richard Syron – have lost their executive positions and mammoth salaries although it appears that each has agreed to stay on to assist in an orderly transition.
• The conservatorship is open-ended in terms of time. The conservator alone will make the determination that the companies have returned to a safe and solvent condition.

There is much about the effects of Sunday's actions that is not known at this time and some who commented on television and print on Sunday seemed shell-shocked by the extent of the action. Several financial reporters commented that Treasury had acted far more broadly than anyone had expected.

Among the current imponderables:

• What is this whole thing going to cost? As stated above, the number $200 billion is being bandied about as a direct cost, but it is impossible to measure the losses that will spread throughout the economy. The common and preferred stock is widely held by individuals, entities such as pension funds, and other financial institutions of all sizes. While these stockholders have already watched their investments plummet in value over the last 18 months, will they lose everything? Several of Paulson's statements on Sunday seem to indicate that possible losses to stockholders in the financial sector may determine the treatment of all stockholders. Pardon the cynicism, but this apparently means that big business interests will be protected.
• How great will be the impact on the housing market? There seems to be a consensus that there will be little impact on the numbers of houses for sale and that home prices will continue to fall; less conviction than hope that mortgage rates will come down. Optimists say the takeover will increase the stability of and confidence in the credit market and could result in a reduction of as much as one quarter to one percent in rates.
• Have lending standards already been tightened sufficiently since the subprime crisis began or are borrowers and lenders in for another round of rules that will make it tougher to obtain or grant financing?
• It appears likely if not certain that fees charged banks for loan securitization services may be reduced which could lower the costs of obtaining loans.
• What will happen to homeowners who are already in trouble with their mortgages? In the case of the recent closing of IndyMac Bank the FDIC almost immediately announced a program to assist these borrowers and it is clear that the government has no desire to own hundreds of thousands of foreclosed homes. Some commentators mentioned an expansion of the Hope Now program, but the sheer magnitude of the problem could be overwhelming.

Immediate reactions to Paulson's announcement on Sunday were mixed although most reactors seemed to feel it was appropriate and inevitable. Some questions were raised as to whether the takeover was too radical or did not go far enough. The presidential candidates expressed a range of support for the Conservatorship. Barack Obama commented on ABC's This Week that he felt no class of investors or debtors should carry more of the burden than others. The Republican candidates both applauded the action.

The impact on the stock market cannot yet be determined although the Asian markets were reacting favorably as was the futures market. It will be an interesting day on Wall Street.

The Conservatorship will obviously be big news for many months. We will periodically update the reactions and the effects as they become known.