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This following article was found on Wikipedia. http://en.wikipedia.org/wiki/Federal_takeover_of_Fannie_Mae_and_Freddie_Mac

The federal takeover of Fannie Mae and Freddie Mac is one event in a continuing series of unexpected financial restructurings in the 2008 credit crisis among major and minor United States financial firms. Leading factors in the crisis are losses, impairment of capital, and loss of market confidence related to the subprime mortgage crisis.

The director of the Federal Housing Finance Agency (FHFA), James B. Lockhart III. on September 7, 2008 announced his decision to place two Government sponsored enterprises (GSEs) Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), into conservatorship run by FHFA. Secretary Paulson at the same press conference stated that placing the two GSEs into conservatorship was a decision he fully supported, and said that he advised “that conservatorship was the only form in which I would commit taxpayer money to the GSEs.” He further said that “I attribute the need for today’s action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction.” The same day, Federal Reserve Bank Chairman Ben Bernanke stated in support: “I strongly endorse both the decision by FHFA Director Lockhart to place Fannie Mae and Freddie Mac into conservatorship and the actions taken by Treasury Secretary Paulson to ensure the financial soundness of those two companies.”

Background and financial market crisis

The combined GSE losses of $14.9 billion and market concerns about their ability to raise capital and debt threatened to disrupt the U.S. housing financial market. The Treasury committed to invest as much as $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent and operating. The two GSEs have outstanding more than US$ 5 trillion in mortgage backed securities (MBS) and debt; the debt portion alone is $1.6 trillion. The conservatorship action has been described as “one of the most sweeping government interventions in private financial markets in decades, “and one that “could turn into the biggest and costliest government bailout ever of private companies”.

With a growing sense of crisis in U.S. financial markets, the conservatorship action and commitment by the U.S. government to backstop the two GSEs with up to US$ 200 billion in additional capital did not prevent a subsequently tumultuous week among investment banking and financial institutions. By September 15, 2008, the 158 year-old Lehman Brothers holding company filed for bankruptcy with intent to liquidate its assetts, leaving its financially sound subsidiaries operational and outside of the bankruptcy filing. The collapse is the largest investment bank failure since Drexel Burnham Lambert in 1990. The 94 year-old Merril Lynch accepted a purchase offer by Bank of America for approximately US$ 50 billion, a big drop from a year-earlier market valuation of about US$ 100 billion. Concerns continued about the capital reserves and solvency of large insurer American International Group (AIG) which sought a US$ 40 billion dollar secured loan from the Federal Reserve Bank, and the country’s largest savings bank, Washington Mutual.

 Federal Housing Finance Agency and Treasury authority

The Housing and Economic Recovery Act of 2008—passed by the United States Congress on July 24, 2008 and signed into law by President George W. Bush on July 30, 2008—enabled expanded regulatory authority over Fannie Mae and Freddie Mac by the newly established FHFA, and gave the U.S. Treasury the authority to advance funds for the purpose of stabilizing Fannie Mae, or Freddie Mac, limited only by the amount of debt that the entire federal government is permitted by law to commit to. The law raised the Treasury’s debt ceiling by US$ 800 billion, to a total of US$ 10.7 trillion, in anticipation of the potential need for the Treasury to have the flexibility to support Fannie Mae, Freddie Mac, or the Federal Home Loan Banks.

 Prior GSE support measures

The September 7 conservatorship was been termed by the Economist as the “second” bailout of the GSEs. Prior to the enactment of the Housing and Economic Recovery Act of 2008, on July 13, 2008, Treasury Secretary Henry Paulson announced an effort to backstop the GSEs based on prior statutory authority, in coordination with the Federal Reserve Bank. That announcement occurred after a week in which the market values of shares of Fannie Mae and Freddie Mac fell almost by half (from a previously diminished value of approximately half of year-earlier market highs). That plan contained three measures: an increase in the line of credit available to the GSEs from the Treasury, so as to provide liquidity; the right for the Treasury to purchase equity in the GSEs, so as to provide capital; and a consultative role for the Federal Reserve in a reformed GSE regulatory system. On the same day, the Federal Reserve announced that the Federal Reserve Bank of New York would have the right to lend to the GSEs as necessary.

Capital infusion by the Treasury

The agreement the Treasury made with both GSEs specifies that in exchange for future support and capital investments of up to US$ 100 billion in each GSE, at the inception of the conservatorship, each GSE shall issue to the Treasury US$ 1 billion of senior preferred stock, with a 10% coupon, without cost to the Treasury.Also each GSE contracted to issue common stock warrants representing an ownership stake of 79.9%, at an exercise price of one-thousandth of a U.S. cent ($ 0.00001) per share, and with a warrant duration of twenty years.

The conservator, FHFA signed the agreements on behalf of the GSAs.The 100 billion amount for each GSE was chosen to indicate the level of commitment that the U.S. Treasury is willing to make to keep the financial operations and financial conditions solvent and sustainable for both GSEs. The agreements were designed to protect the senior and subordinated debt and the mortgage backed securities of the GSEs. The GSEs’ common stock and existing preferred shareholders will bear any losses ahead of the government. Among other conditions of the agreement, each GSE’s retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion.

Market consequences

Bank reserves

Many commercial banks in the United States own Freddie and Fannie preferred shares. Those shares have had their dividends suspended, and are junior to the senior preferred stock issued to the Treasury in the restructuring of the two companies. The market value of the preferred shares plunged after the restructuring announcement and suspension of dividends. Banks will be required to write down the value of Freddie and Fannie preferred stock held in their portfolios, compounding capitalization concerns for certain U.S. banks.

 Credit Default Swaps

In the credit default swap (CDS) market, the standard contracts typically used between parties to a swap define the action of placing Fannie Mae and Freddie Mac into conservatorship to be equivalent to bankruptcy, because of the change in management control. In CDS parlance, this is termed a credit event, and that triggers the settling of outstanding contracts for the derivatives, which are used to hedge or speculate on the potential risk that a company will default on its bonds. The two GSEs have approximately US$ 1.5 trillion in bonds outstanding, and since the market in credit default swaps is not public, there is no central reporting mechanism to verify how many credit default swaps are linked to those bonds. One estimate floated is US$ 500 billion, and that the entire CDS market has a notional value in the vicinity of US$ 62 trillion. Settlement on the contracts, will likely be the largest in the market’s decade-long history. Credit-default swaps on Fannie and Freddie have been among the most actively traded the several months leading up to the conservatorship. “Thirteen ‘major’ dealers of credit-default swaps agreed ‘unanimously’ that the rescue constitutes a credit event triggering payment or delivery of the companies’ bonds,” according to a memo circulated by the International Swaps and Derivatives Association (ISDA) after the conservatorship announcement. The day after the conservatorship announcement, the International Swaps and Derivatives Association, which sets industry standardized contracts for financial derivatives and swaps, announced it was working on a protocol on how to evaluate and settle Fannie Mae and Freddie Mac credit default swaps.

Paradoxically (in relation to typical experiences when a company issuing bonds has a “credit event”), the value of the two GSEs bonds rose to the vicinity of par value after the conservatorship. This means, that some owners of swaps that were hedging against the risk of a bond default, may be worse off, since the value of the bonds may be higher than when they purchased the swap. Cash auctions are reported to be scheduled for October 2008 to settle CDS contracts in relation to the GSEs.

 Reactions to the seizure

The immediate reactions in the finance markets on Monday September 8, the day following the seizure, appeared to indicate satisfaction with at least the short-term implications of the Treasury’s intervention. Governor of the Bank of Japan Masaaki Shirakawa stated “We expect the action would lead to stabilize the U.S. [mortgage-backed securities] market, financial market and the international financial market.” Governor of the People’s Bank of China, China’s central bank, Zhou Xiaochuan stated “From my point of view this is positive”.

 Effects on the subprime mortgage crisis

The effects on the subprime mortgage crisis have led the government to support the soundness of the obligations and guarantees on securities issued by Fannie and Freddie to obtain funds. Those funds are in turn used to purchase mortgages from originating banks. The continuing soundness of GSE obligations enhances market liquidity (loanable funds) in the following ways

• Banks can be assured that Fannie and Freddie have funds to purchase conforming loans, so they can increase such lending. This improves liquidity in the mortgage market, lowering interest rates.
• Lower borrowing costs for banks typically increase the “spread” between the rate at which they borrow and which they lend. This increases bank profitability, shoring up bank liquidity and balance sheets further.
• Adjustable rate mortgage (ARM) rates are reduced, which lowers pressure on homeowners and reduces foreclosures. Lower rates also encourage new home purchases.
• The government’s role as the primary investor allows a systematic loan refinancing process to be implemented. This should enable rapid loan adjustments or workouts for homeowners, which have been facing bottlenecks due to the requirement to have various investors approve the adjustments For example, the government could rapidly push-down 45-year mortgage terms and fixed, low interest rates, enabling many more homeowners to stay in their homes. This will reduce foreclosures significantly, helping to stabilize home prices.
• The government can restructure mortgages so that the loan balance is reduced to the current market value, reducing the incentive for homeowners to “walk away” from the property.
• With home prices more stabilized, the value of mortgage-backed securities receives some upward support.