Bailout fears leave US home loan giants Freddie and Fannie reeling

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Shares of Fannie Mae and Freddie Mac plunged yesterday as speculation mounted that the US government would be forced to take control of the mortgage finance companies that underpin the US housing market.

Both companies lost about half their value in early trading in New York but clawed back some of the deficit after government reassurances.

Fannie Mae and Freddie Mac are government-sponsored companies that buy mortgages, package them into bonds and sell them to investors. They also hold mortgages in their own portfolios. They support the market by providing certainty of payment to buyers of mortgage-backed securities.

Hank Paulson, the US Treasury Secretary, tried to reassure the market that Fannie Mae and Freddie Mac could keep operating and that no emergency government action was imminent. "Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission," Mr Paulson said.

His remarks helped the shares to stage a partial recovery, but Fannie closed down 22.4 per cent and Freddie shed 3.1 per cent.

The companies' woes dragged down shares of US investment banks, which have been battered by writedowns on holdings of mortgage-linked securities as defaults on home loans have rocketed. Lehman Brothers shares were down 28 per cent in lunchtime trading.

The companies' implicit government guarantee allows them to fund for less than rivals without the government backing and has let them keep operating amid the financial turmoil.

Fannie and Freddie have grown in importance during the credit crunch because investors are unwilling to buy any mortgage-backed securities without their backing. They accounted for 98 per cent of the mortgage bond market in March compared with less than half a year earlier, according to UBS. Their failure would therefore be cataclysmic for a US housing market in crisis.

Congress created Fannie during the Great Depression and Freddie in 1970 to protect against regional credit crunches that occurred when banks were hit by local downturns. But fears have grown that further losses on their holdings could threaten their financial position.

The government can put the companies into a "conservatorship" under their regulator if "critical capital" drops below guidelines. The measure would make the company's shares worth ittle or nothing. Regulators and government officials have said repeatedly that Fannie and Freddie are adequately capitalised.

Mortgage rates would jump if Fannie and Freddie could not operate, putting extra pressure on homeowners and damaging confidence in the market still further.

John McCain, the Republican presidential nominee, said the companies were "vital to Americans' ability to own their own homes" and "they must not fail".

The US Treasury and the Bush administration were said to have discussed contingency plans for a rescue of the companies but no action would be taken unless they were significantly short of capital.

Panic over Fannie and Freddie set in on Monday after an analyst's report said proposed accounting changes could force them to take mortgages back on to their books, triggering $75bn of regulatory capital charges.

The companies have together raised about $20bn since the fourth quarter of 2007, about double their losses in the same period. Freddie Mac plans to raise another $5.5bn.

The companies would have to lose $77bn between them to be considered insolvent, Fox-Pitt Kelton analysts said. For that to happen to Fannie Mae there would have to be massive rates of default on mortgages and a 40 per cent fall in house prices, they added.

Duo underpin US market

Freddie Mac and Fannie Mae are US-government sponsored bond issuers that underpin the US mortgage market. Between them, they own or guarantee $5.2 trillion worth of mortgages – almost half of the US market.

Fannie Mae, formally the Federal National Mortgage Association, was created in the Depression to support the housing market. It was joined by the Federal Home Loan Mortgage Corp, aka Freddie Mac, in the 1970s in another attempt to stimulate the supply of new housing.

The companies, which are publicly owned and listed on the New York Stock Exchange, are regulated by the Office of Federal Housing and Enterprise Oversight.

Although set up by the US government, the companies have never had an explicit government guarantee. As expectations of a bailout have mounted this week, investors have been selling the shares and buying their bonds instead, calculating that a state takeover would give their debt a clear government guarantee.