International Herald Tribune - Published: July 10, 2008

Henry Paulson Jr., U.S. Treasury Secretary, left, testifying Thursday at a House Financial Services Committee hearing in Washington as Ben Bernanke, chairman of the Federal Reserve, right, takes notes. (Brendan Smialowski/Bloomberg News)

By Stephen Labaton

WASHINGTON: Top officials in Washington struggled Thursday to reassure the markets about the financial health of the nation’s two largest mortgage finance companies as their stock prices plunged to their lowest levels in 17 years on fears that they could face the possibility of a government bailout.

The rapid sell-off of shares of Fannie Mae and Freddie Mac followed comments from a former central banker that the institutions might not be solvent, as well as a critical report about Freddie from an analyst at UBS.

The turmoil also shook the debt of the government-sponsored companies, as the gap between the yield on Fannie Mae bonds and ultrasafe U.S. Treasury bonds widened to the highest level since the days before the Fed rescued Bear Stearns from bankruptcy in March.

At a congressional hearing Thursday morning, both the Treasury secretary, Henry Paulson Jr., and the Federal Reserve chairman, Ben Bernanke, said that the regulator of both Fannie and Freddie had found that they were, in the words of Paulson “adequately capitalized.”

“Fannie Mae and Freddie Mac are also working through this challenging period,” Paulson said early in his testimony before the Financial Services Committee of the House of Representatives. “They play an important role in our housing markets today and need to continue to play an important role in the future. Their regulator has made clear that they are adequately capitalized.”

Bernanke said that Fannie and Freddie were “well capitalized in the regulatory sense,” but added that they, along with other major financial institutions, needed to raise their capital levels.

The two companies play a central role in the marketplace by buying hundreds of billions of dollars in mortgages from lenders, repackaging them as securities and then either holding them in their portfolios or selling them to investors.

While their shares trade on the New York Stock Exchange, they were created by Congress to promote housing, and most investors are convinced that they would be bailed out should they become insolvent. They hold a far lower level of capital than banks. In recent years, they have both suffered from accounting scandals and management shake-ups.

On Thursday, Senator John McCain, the presumptive Republican candidate for president, said he supported government intervention if needed to save Fannie or Freddie from collapsing.

“Those institutions, Fannie and Freddie, have been responsible for millions of Americans to be able to own their own homes, and they will not fail, we will not allow them to fail,” McCain said during a campaign stop in Livonia, Michigan. “And we will do what’s necessary to make sure that they continue that function.”

Despite the assurances at the hearing before the House Financial Services Committee, both Paulson and Bernanke were guarded on their overall assessment of the problems confronting the mortgage finance companies, clearly concerned that they did not want to say anything that could further erode confidence in them.

Neither official would address a question posed by Representative Dennis Moore, a Kansas Democrat, who asked whether the failure of either institution would pose a risk to the entire U.S. financial system.

“In today’s world I don’t think it is helpful to discuss any financial institutions and whether they pose systemic risk,” Paulson said.

Nor would they answer a question about whether Congress needed to give the regulators more tools to deal with the possible insolvency at either company.

“I don’t think we should be speculating about what if’s with Fannie and Freddie,” Paulson said, as Bernanke sat silently at his side.

Representatives of Fannie Mae did not return calls seeking comment; a Freddie Mac spokeswoman noted that its regulator had assured investors it was adequately capitalized.

After falling sharply earlier in the week, Freddie Mac’s stock plunged 34 percent and Fannie Mae’s 23.5 percent in early trading Thursday. In afternoon trading, Freddie Mac was down $1.97, or 19.2 percent, at $8.29, and Fannie Mae was down $1.70, or 11.1 percent, at $13.61.

A collapse at either of the two companies, which operate under an implicit government guarantee, could cause catastrophic consequences for the U.S. economy. Analysts said they expected the companies to announce a new round of write-downs and possibly be required to issue more stock, which would dilute the value of the shares currently held by investors.

Expectations of default at the companies have risen in the markets; it costs three times as much today to guarantee a two-year Fannie note as it did three years ago.

“If you have to borrow at a high rate, and what you buy with that borrowed money pays you only a small amount, then you’re not earning enough to cover expenses, and that’s when companies go out of business,” said Sean Egan, managing director of Egan-Jones Ratings, an independent credit ratings business. “In the absence of any sort of federal guarantee of these companies’ debt, they effectively go into bankruptcy.”

Freddie Mac had previously announced that it intended to raise $5.5 billion this year. Both Freddie and Fannie are widely expected to post additional losses this year that would require them to raise more money from investors. But with their stock prices plummeting, such fund-raising may be made difficult.

The market problems for the two companies were prompted in part by comments by a former president of the Federal Reserve Bank of St. Louis, William Poole. During an interview Wednesday, Poole, a longtime critic of the two companies, called Fannie and Freddie “insolvent” and said the government might be required to rescue them.

“Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,” Poole told Bloomberg News.

During an interview with The New York Times, Poole said it “may be impossible” for Fannie and Freddie to raise new capital. “We are potentially looking a crisis in the face, and we must not allow this to happen. The government must intervene.”

source: IHT

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