WASHINGTON (AP) -- The Bush administration seized control Sunday of troubled mortgage giants Fannie Mae and Freddie Mac, aiming to stabilize the housing market turmoil that is threatening financial markets and the overall economy.
Treasury Secretary Henry Paulson is betting that providing fresh capital to the two firms will eventually lead to lower mortgage rates, spur homebuying demand and slow the plunge in home prices that has ravaged many areas of the country.
The huge potential liabilities facing each company, as a result of soaring mortgage defaults, could cost taxpayers tens of billions of dollars, but Paulson stressed that the financial impacts if the two companies had been allowed to fail would be far more serious.
"A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance," Paulson said.
But more importantly, "Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe," he added in a televised announcement.
The companies, which together own or guarantee about $5 trillion in home loans, about half the nation's total, have lost $14 billion in the last year and are likely to pile up billions more in losses until the housing market begins to recover.
Democratic presidential nominee Barack Obama issued a statement agreeing that some form of intervention was necessary, and promised, "I will be reviewing the details of the Treasury plan and monitoring its impact to determine whether it achieves the key benchmarks I believe are necessary to address this crisis."
On Saturday, Republican vice presidential nominee Sarah Palin said Fannie and Freddie "have gotten too big and too expensive to the taxpayers. The McCain-Palin administration will make them smaller and smarter and more effective for homeowners who need help."
Both companies were placed into a government conservatorship that will be run by the Federal Housing Finance Agency, the new agency created by Congress this summer to regulate Fannie and Freddie.
The executives and board of directors of both institutions are being replaced. Herb Allison, a former vice chairman of Merrill Lynch, was selected to head Fannie Mae, and David Moffett, a former vice chairman of US Bancorp, was picked to head Freddie Mac.
Paulson was careful not to blame Daniel Mudd, the outgoing CEO of Fannie Mae, or Freddie Mac's departing CEO Richard Syron for the companies' current problems. While both men are being removed as the top executives, they have been asked to remain for an unspecified period to help with the transition.
The Treasury Department said it will immediately inject $1 billion in each of the companies through the purchase of senior preferred stock, paying 10 percent interest, and could boost its investment to as much as $100 billion each over time if the funds are needed to keep the companies afloat as losses mount. In exchange, the government will receive warrants entitling it to purchase ownership stakes of 79.9 percent in each.
Officials defended this approach by saying it underscores the importance of the trillions in mortgage debt that each company either holds or guarantees and the need to make sure that investors in this country and overseas keep buying this debt.
In addition, officials said the Treasury Department plans to purchase $5 billion in mortgage-backed debt from the two companies later this month.
The impact on existing common and preferred shares, which have slumped in value in the last year, will depend on how investors react to Paulson's assertion that they must absorb the cost of further losses first.
The Federal Reserve and other federal banking regulators said in a joint statement Sunday that "a limited number of smaller institutions" have significant holdings of common or preferred stock shares in Fannie and Freddie, and that regulators were "prepared to work with these institutions to develop capital-restoration plans."
The two companies had nearly $36 billion in preferred shares outstanding as of June 30, according to filings with the Securities and Exchange Commission.
Under government control, the companies will be allowed to expand their support for the mortgage market over the next year by boosting their holdings of mortgage securities they hold on their books from a combined $1.5 trillion to $1.7 trillion.
Starting in 2010, though, they are required to drop their holdings by 10 percent annually until they reach a combined $500 billion.
Paulson said that it would be up to Congress and the next president to figure out the two companies' ultimate structure and the conflicting goals they operated under - maximizing returns for shareholders while also being required to encourage home buying for low- and moderate-income Americans.
"There is a consensus today ... that they cannot continue in their current form," he said.
Paulson and James Lockhart, director of the Federal Housing Finance Agency, stressed that their actions were designed to strengthen the role of the two mortgage giants in supporting the nation's housing market. Both companies do that by buying mortgage loans from banks and packaging those loans into securities that they either hold or sell to U.S. and foreign investors.
Lockhart said dividends on both common and preferred stock would be eliminated, saving about $2 billion a year. He said that all lobbying activities of both companies would stop immediately. Both companies over the years made extensive efforts to lobby members of Congress in an effort to keep the benefits they enjoyed as government-sponsored enterprises.