Mortgage Giants Fannie and Freddie (FNM, FRE) Enter Conservatorship, Common and Preferred Holders To Bear First Losses

September 7, 2008 11:37 AM EDT

As expected, Henry Paulson and the U.S. Treasury announced today that they will take action on the GSEs, Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), putting the two into a conservatorship with the Federal Housing Finance Agency (FHFA).

Paulson said, based on condition of financial markets today, he concluded that it would not have been in the best interest of the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form.

New CEOs supported by new non-executive Chairmen have taken over management of the GSEs. Departing CEOs, Dan Mudd and Dick Syron, have agreed to stay on for a period to help with the transition.

To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.

Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares. On the common stock, the agency said, "While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise." On the preferred stock, the agency said, "Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders." Also, the common stock and preferred stock dividends will be eliminated.

Treasury also announced the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.

Also, to support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS.

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