Markets Cheer Fannie, Freddie Takeover

The Fannie Mae and Freddie Mac bailout: Get a little excited—but just a little.

The most dramatic move by regulators so far to end the credit crisis sent stocks up Monday, but the cheering cooled as questions emerged over just how much the plan to shore up the government-sponsored lenders will really help.

The government's decision to place Fannie and Freddie into conservatorship (see background here and here) bolsters hopes that this latest intervention will provide the necessary spark to finally revive lenders and investors who have shunned all manner of risk-taking and new investment for the better part of the past year. The rescue comes after Friday's surprise jump in new foreclosures mixed with last week's market slump that had some investors worried that stocks could push back toward yearly lows set in July. This deal ended such talk, at least for today.

"On the margin, it's positive for one of the biggest issues in the U.S. economy," said Stuart Hoffman, chief economist at PNC Financial Services Group. "There's a positive reaction any time uncertainty is cleared up. Most people feel good about it. It was the least evil of all paths."

Led by a rally in financial stocks, the Dow jumped 250 points this morning before settling back, while Fannie and Freddie shares lost more than 80 percent of their already decimated values. By noon, however, the market's wider gains were pared as those same financial firms, including Washington Mutual (WM), which soared 20 percent on news of the departure of CEO Kerry Killinger, reversed.

The market's response underscores just how much depends on getting the credit crisis under control and just how unconvinced some investors remain about real progress in improving markets or the economy.

What remains to be seen is if this latest and by far largest bailout can accomplish what increased Federal Reserve lending, interest rate cuts, and the May bailout of Bear Stearns ultimately failed to do: keep mortgage rates from spiking and restore calm to lenders still unwilling to turn cash taps back on.

At first glance, analysts are optimistic that the move can finally crack dammed-up investment by bringing down mortgage rates and improve the availability of credit. Treasury bond prices fell Monday as investors left such safe-haven assets, following the announcement that the Treasury would buy mortgage securities in the open market. The housing market still faces rising foreclosures, falling prices, and a large inventory of unsold homes, but right now market investors are simply looking for any sign that the worst is over in housing. With a plan for the GSEs (government-sponsored enterprises) in place, housing is one step closer to hitting bottom.

Merrill Lynch agrees Treasury is "bringing out the 'bazooka' " with this bailout but questions its lasting effects on markets:

This is yet another example that policy officials remain in reactive mode just as they were that weekend in mid-March when the Fed orchestrated the BSC takeover; and again in mid-July when the government made the guaranty of GSE mortgages more explicit.

In both instances, the equity markets appeared to be falling off the table to only then enjoy a brief short-covering rally, led by the financials. Considering that the first weekend intervention in mid-March resulted in a powerful two-month bear market rally, and the second weekend intervention in mid-July only provided about two weeks of recovery, one has to wonder whether this third weekend intervention is going to have much staying power at all.

Goldman Sachs calls it a "very positive step" but keeps an eye toward what it could cost taxpayers:

The main benefit is the avoidance of a worst-case scenario in which the GSEs reduced lending to conserve capital. While the move comes with important fiscal consequences and leaves some uncertainty about the longer term prospects of these companies, the macro benefits outweigh these issues.

The losers in all this will be Fannie and Freddie shareholders, who lose their dividend and very likely face a near washout of their investment as the government wins the right to take 80 percent of each company. Bondholders will most likely recoup some of their investment.

Optimism should also be tempered because this bailout implies less that the mortgage market can be saved once and for all and more that the "bright new system" of global finance spurred by low inflation and constant growth "has broken down," as former Fed Chair Paul Volcker said on Friday. Speaking at a banking conference in Calgary, he said, "Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.''

Also, many on Wall Street still see regulators as playing defense. Just a couple of months ago, Paulson reassured markets that the GSEs would most likely remain independent.

It's also not at all clear what this move will cost taxpayers. Estimates being tossed about range from $25 billion to as high as $300 billion. The Treasury has promised up to $200 billion to pay fund losses stemming from rising defaults in the GSEs' combined $5.4 trillion portfolio of U.S. mortgages.

(Another question: Who has been buying up the mortgages that the government is now going to invest in? Pacific Investment Management Co., which runs the world's largest bond fund, reportedly backed up the truck for mortgage-backed bonds.)

All this comes at a time when consumer spending, economic growth, and rising joblessness threaten second-half growth. The latest bailout will probably instill some confidence in the market, but worries over the global economy aren't going anywhere.

"These are relatively small moves in the right direction but not enough to move the macro needle," says PNC's Hoffman.