The U.S. Treasury and the Federal Reserve announced steps Sunday to shore up mortgage giants Fannie Mae and Freddie Mac, which are based in Washington, D.C., and in McLean, Va., respectively. (Pablo Martinez Monsivais/Associated Press)

The U.S. Federal Reserve and the Treasury announced steps Sunday to shore up mortgage giants Fannie Mae and Freddie Mac, whose shares have plunged as losses from their mortgage holdings threatened their financial survival.

The steps are also intended to send a signal to nervous investors worldwide that the government is prepared to take all necessary steps to prevent the credit market troubles that started last year with losses from subprime mortgages from engulfing financial markets and further weakening the economy and housing markets.

The Fed said it granted the Federal Reserve Bank of New York authority to lend to the two companies "should such lending prove necessary." They would pay 2.25 per cent for any borrowed funds, the same rate given to commercial banks and big Wall Street firms.

The Fed said this should help the companies' ability to "promote the availability of home mortgage credit during a period of stress in financial markets."

Secretary Henry Paulson said the Treasury is seeking expedited authority from Congress to expand its current line of credit to the two companies should they need to tap it and to make an equity investment in the companies, if needed.

"Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owner companies," Paulson said Sunday. "Their support for the housing market is particularly important as we work through the current housing correction."

The Treasury's plan also seeks a "consultative role" for the Fed in any new regulatory framework eventually decided by Congress for Fannie and Freddie. The Fed's role would be to weigh in on setting capital requirements for the companies.

Bush steps in

The White House issued a release, saying President George W. Bush had directed Paulson to "immediately work with Congress" to get the plan enacted. It also said it believed the plan outlined by Paulson "will help add stability during this period."

Investors may not be as sanguine, according to Chris Johnson, an investment manager and president of Johnson Research Group in Cleveland, Ohio.

Stocks of financial institutions "are going to get clobbered," he predicted. "It is a situation where regulators and the government are trying to play catch-up, and that means everything is not discounted in the stock prices yet."

The Dow Jones industrials on Friday briefly fell below 11,000 for the first time in two years and Johnson expects shares of investment banks and regional banks could notch even lower as investors react to this weekend's developments.

Fannie Mae and Freddie Mac either hold or back $5.3 trillion US of mortgage debt. That's about half the outstanding mortgages in the United States.

Fannie was created by the government in 1938 to provide more Americans the chance to own a home by giving financial institutions an outlet to sell mortgage loans they originated, freeing more cash to make more home loans. It moved from government to public ownership in 1968 and Freddie was started two years later.

Government faces criticism

Sunday's announcements are likely to raise anew criticism that the government should have moved sooner to rein in the two companies, especially since investors widely assumed they would be bailed out if they got into trouble.

The government denied it, but what was seen by investors as an implicit guarantee of support allowed Fannie and Freddie to borrow at rates only slightly higher than the Treasury and lower than what their banking competitors had to pay.

"This really blows away the notion of an implicit guarantee," independent banking consultant Bert Ely said of the Treasury's plan to ask Congress to allow it to make equity investments in Fannie Mae and Freddie Mac. "It suggests a greater concern about how these companies are doing. It says the problems are deeper. It gets to the solvency of the companies, not just the liquidity."

Critical test

The announcement marked the latest move by the government to bolster confidence in the mortgage companies. A critical test of confidence will come Monday morning, when Freddie Mac is slated to auction a combined $3 billion US in three- and six-month securities.

Paulson's goal is to get his plan attached to a sweeping housing-rescue package. The Senate and House have each passed bills and a final package has to be hammered out. The centrepiece of the legislation is to help strapped homeowners avoid foreclosure legislation, but it also contains provisions to revamp oversight of Fannie Mae and Freddie Mac.

"Treasury's plan is surgical and carefully thought out and will maximize confidence in Fannie and Freddie while minimizing potential costs to U.S. taxpayers," said Senator Charles Schumer, a New York Democrat.

House GOP leader John Boehner and Republican Whip Roy Blunt said they "stand ready to work with Secretary Paulson and congressional Democrats to take appropriate steps to ensure the soundness of our mortgage markets."

Officials from Treasury, the Fed and other regulators worked in close consultation throughout the weekend after growing investor fears about the companies' finances sent their shares and the overall market plummeting last week.

Shares plunge

Shares of Fannie Mae plunged 45 per cent last week and are down 74 per cent since the beginning of the year. Freddie Mac shares fell 47 per cent last week, and have fallen 77 per cent so far this year.

Freddie Mac chairman Richard Syron said Sunday that preliminary second-quarter results show that his company had "a substantial capital cushion" above the 20 per cent minimum surplus it is required to maintain.

Fannie Mae president and CEO Daniel Mudd said he believes the steps could send a calming message.

"Given the market turmoil, having options to access provisional sources of liquidity if needed will help to strengthen overall confidence in the market," he said. "We will continue to do our part to provide liquidity, stability and affordability to the housing market now and in the future."

A senior Treasury official said any increase in the line of credit — now at $2.25 billion US for each company — would be at the Treasury secretary's discretion. The same would apply to any equity investment made by the government.