Fannie Mae, Freddie Mac: Investors Flee

The stocks plummeted as proposals to provide Federal support to the troubled government-sponsored mortgage brokers failed to reassure shareholders

It's not often that Federal Reserve Chairman Ben Bernanke plays second fiddle when he makes his twice-yearly trip to Capitol Hill to outline his current outlook on monetary policy and the economy.

But with all eyes on the extensive proposals put forth on July 13 by U.S. Treasury Secretary Henry Paulson and the Fed to restore confidence in Fannie Mae (FNM) and Freddie Mac (FRE), the struggling mortgage giants at the heart of the escalating credit crunch, much of the focus when the Senate Banking Committee met for Bernanke's testimony on July 15 came in the second act.

Bernanke testified for 90 minutes on everything from the risks facing the economy (he warned of "significant downside risks to the outlook for growth" even as the threat of inflation is growing) to his views on oil speculation (he doesn't think speculative activity or manipulation is a big cause of the recent runup in oil prices).

Stabilizing Move, or a Bailout?

The hearings then turned to the real heart of the matter: In a regulatory triple-play of sorts, Bernanke was joined at the Banking Committee hearings by Paulson and Securities and Exchange Commission Chairman Christopher Cox to argue for the package of recent proposals regulators have put forth to provide explicit Federal support to the troubled government sponsored enterprises (GSEs). (Fannie and Freddie are known as GSEs because of their unique status—while chartered by the Federal government to provide backing to the mortgage market, they're owned by public shareholders.)

At the core of those proposals, as outlined by Paulson, is a request that Congress grant Treasury a temporary increase in the credit line it can extend to the GSEs, as well as the ability to purchase equity in the firms should that prove necessary. The moves are designed to reassure bond and stock investors that Fannie and Freddie will have both the liquidity and the capital needed to weather the current crisis, key to getting the markets, and ultimately the economy, back on track. With the Treasury proposal in the works, the Fed also agreed to temporarily grant the GSEs access to the Fed's discount window, should they need emergency liquidity before Congress can authorize the Treasury moves. "The GSEs now touch 70% of new mortgages and represent the only functioning secondary mortgage market," Paulson told the senators. "The GSEs are central to the availability of housing finance, which will determine the pace at which we emerge from this housing correction."

But the proposals have already proven controversial. While backers hope the moves will end fears that losses on mortgage and mortgage-related securities will overwhelm the two critical firms—which together own or guarantee roughly half the mortgages in the U.S.—critics fear such action will open the door to a government-financed bailout that could ultimately cost U.S. taxpayers tens if not hundreds of billions of dollars. Critics also argue that regulators have been too quick to bail out Wall Street, a charge that Paulson, a former chairman and CEO of Goldman Sachs (GS), tried to deflect. "Our plan is aimed at supporting the stability of financial markets, not just these two enterprises," he said.

Temporary Backup

The biggest concern is the open-ended nature of Paulson's request. Currently, the GSEs have a $2.25 billion line of credit with the Treasury, a sum that was established in 1971 when both firms were miniscule compared with today. Now Paulson has asked for an open-ended, unlimited authority from Congress to allow it to buy shares of or lend funds to the mortgage giants should they need funds. Despite repeated attempts by senators on the Banking Committee to pin him down to what the cost to taxpayers could be, Paulson declined to be specific. And he repeatedly insisted that the Treasury has no current plans to put any funds into either Fannie or Freddie.

"I see very clearly that the way to minimize the chance that this facility will ever be called upon will be to take any questions off the table and provide as much flexibility as possible," Paulson said. Instead, he argued, the very openness and flexibility of the proposal would go a long way toward restoring confidence in the GSEs, and thus make it less likely the government may ultimately need to plow any money into them.

"I'm not here recommending putting taxpayer money into these institutions at this time. I am recommending we increase the backup facility temporarily to minimize the chance that the taxpayer will be involved," he said. "If you have a squirt gun in your pocket, you may have to take it out," he said. "But if you've got a bazooka in your pocket, you may not have to take it out."

Addressing Naked Short-Selling

While Paulson's testimony was primarily devoted to explaining his proposals, Cox used the hearings to announce an emergency move aimed at further stabilizing the mortgage giants. The SEC chairman announced that the agency will limit the ability of traders to sell short the shares of the two GSEs, as well as brokerage firms including Lehman Brothers (LEH), Goldman Sachs (GS), Merrill Lynch (MER) and Morgan Stanley (MS). Critics have argued that excessive short-selling, in some cases fueled by rumors that traders know to be false, has driven the slide in shares of financial firms, including the defunct Bear Stearns.

While the SEC recently announced stepped up efforts to investigate those allegations (, 7/16/08), Cox offered a more concrete measure at the congressional hearings. Traders will be forbidden from selling short the shares of those firms unless they actually hold the shares. The move effectively bans a practice known as naked short-selling, in which traders sell a company's shares without actually owning the underlying stock. Cox said such measures would go into effect for 30 days, and that the SEC is beginning to work on rules that will address the same issues for the broader market as well.

Neither agencies' proposals, however, appear to have reassured Fannie or Freddie investors. With equity holders likely to be hardest hit if any Federal bailout does emerge, shareholders have been fleeing the GSE stocks in droves for the last week. It was no different on July 15. Fannie shares fell 27%, while Freddie shares fell 26%, as investors concluded that even if the Fed actions rescue the agencies, shareholders will be left holding the bag.

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