Markets Calm After Fed Plan for Fannie and Freddie

July 14, 2008— -- The most closely watched trading on Wall Street today will be the stock and debt of Fannie Mae and Freddie Mac to gauge whether the Bush administration's weekend rescue plan for the mortgage giants was sufficient to bolster investor confidence in them.

In an extraordinary one-two punch, the Treasury Department and Federal Reserve took steps Sunday to make as much as $300 billion available to Fannie and Freddie, as the huge mortgage companies are commonly known.

The moves were meant to assure investors that the government will "backstop" the nation's two largest mortgage entities, which guarantee or own nearly half the country's $11 trillion in outstanding mortgage debt.

The Federal Reserve took another step today to restore confidence in the staggering home mortgage industry by adopting rules that would give home buyers greater protection from predatory lenders.

The new rules would bar lenders from making loans without proof of a borrower's income and prohibit lenders from making a loan without considering a borrower's ability to repay.

A mountain of subprime mortgages issued in recent years to first-time home buyers who were unable to afford their debt, particularly when their interest rates began to rise, has caused massive losses among banks, caused the collapse of the venerable Bears Stearns brokerage house, and triggered concern among investors that more institutions will be unable to withstand the losses.

The decision to act on the Fannie and Freddie crisis was made after it "became clear the markets don't have confidence" in Fannie and Freddie, said a Treasury official, who Sunday described them as "way too intertwined with everyone in the world" to allow them to fail. Central banks and small banks alike hold their debt.

The biggest worry was that "all hell would break loose" if the markets opened on Monday and once again their shares went into freefall.

The effort to reassure the markets about Fannie and Freddie and the U.S. financial system appear to be having a calming effect. Stock futures are pointing to a higher open after last week's rout.

It will be a long and tense day, however, and investors will be particularly focused on the reception — and interest rates — Freddie gets in the credit markets later today when it will present two debt offerings totaling $3 billion.

If, after all the intervention by the the federal government, Freddie has trouble getting Wall Street to buy $3 billion in debt, it will be a bad sign. A successful reception would signal that the government action had hit its target.

The result was inconclusive. Demand for the Freddie debt was stronger than it was last week and Fannie and Freddie shares soared early in trading. But both stocks soon fizzled before noon.

The entire stock market will be holding its breath. The Dow Jones industrials on Friday briefly fell below 11,000 for the first time in two years.

The effort to protect Fannie and Freddie came just days after the Federal Deposit Insurance Co. was forced to temporarily shut down the IndyMac bank in California and take over its operations after a run on its funds pushed IndyMac into insolvency. IndayMac, the third largest bank failure in U.S. history, reopens today under new federal management.

With the collapse of Bear Stearns still fresh in its mind, the federal government acted decisively Sunday evening to shore up the confidence of investors who had lost faith in Freddie and Fannie.

The proposals from the Treasury Department were formulated with the hope of insuring stability in the mortgage markets and in the stock market. The plan would give the government the authority to buy Fannie and Freddie stock if other investors are unwilling to do so. It would also reportedly extend their line of credit from a tiny $2.25 billion to as possibly as large as $300 billion.

The plan also seeks to grant greater oversight of the two companies to the Federal Reserve. Lax and loose regulation of the two quasi-government entities is partly to blame for their highly leveraged position. Their $5 trillion in loans are backed by less than $100 billion in cash.

The actions require Congressional approval so, meanwhile, the Federal Reserve announced Sunday night in coordination with the Treasury Department it will open its discount lending window to Fannie and Freddie as it did to struggling investment banks in the aftermath of the Bear Stearns collapse.

Fannie and Freddie can now get loans for up to 90 days if needed. Allowing Freddie and Fannie access to the Fed's money is a temporary, stop-gap measure until the legislation the Treasury asked for is passed.

Sen. Christopher Dodd, D-Conn., chairman of the Senate Banking Committee, today called the Bush administration's actions Sunday "probably the right steps" and said he will summon Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke to a committee hearing Tuesday to answer questions.