Fannie Mae, Freddie Mac: Investors Flee

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Temporary Backup

The biggest concern is the open-ended nature of Paulson's request. Currently, the GSEs have a $2.25 billion line of credit with the Treasury, a sum that was established in 1971 when both firms were miniscule compared with today. Now Paulson has asked for an open-ended, unlimited authority from Congress to allow it to buy shares of or lend funds to the mortgage giants should they need funds. Despite repeated attempts by senators on the Banking Committee to pin him down to what the cost to taxpayers could be, Paulson declined to be specific. And he repeatedly insisted that the Treasury has no current plans to put any funds into either Fannie or Freddie.

"I see very clearly that the way to minimize the chance that this facility will ever be called upon will be to take any questions off the table and provide as much flexibility as possible," Paulson said. Instead, he argued, the very openness and flexibility of the proposal would go a long way toward restoring confidence in the GSEs, and thus make it less likely the government may ultimately need to plow any money into them.

"I'm not here recommending putting taxpayer money into these institutions at this time. I am recommending we increase the backup facility temporarily to minimize the chance that the taxpayer will be involved," he said. "If you have a squirt gun in your pocket, you may have to take it out," he said. "But if you've got a bazooka in your pocket, you may not have to take it out."

Addressing Naked Short-Selling

While Paulson's testimony was primarily devoted to explaining his proposals, Cox used the hearings to announce an emergency move aimed at further stabilizing the mortgage giants. The SEC chairman announced that the agency will limit the ability of traders to sell short the shares of the two GSEs, as well as brokerage firms including Lehman Brothers (LEH), Goldman Sachs (GS), Merrill Lynch (MER) and Morgan Stanley (MS). Critics have argued that excessive short-selling, in some cases fueled by rumors that traders know to be false, has driven the slide in shares of financial firms, including the defunct Bear Stearns.

While the SEC recently announced stepped up efforts to investigate those allegations (BusinessWeek.com, 7/16/08), Cox offered a more concrete measure at the congressional hearings. Traders will be forbidden from selling short the shares of those firms unless they actually hold the shares. The move effectively bans a practice known as naked short-selling, in which traders sell a company's shares without actually owning the underlying stock. Cox said such measures would go into effect for 30 days, and that the SEC is beginning to work on rules that will address the same issues for the broader market as well.

Neither agencies' proposals, however, appear to have reassured Fannie or Freddie investors. With equity holders likely to be hardest hit if any Federal bailout does emerge, shareholders have been fleeing the GSE stocks in droves for the last week. It was no different on July 15. Fannie shares fell 27%, while Freddie shares fell 26%, as investors concluded that even if the Fed actions rescue the agencies, shareholders will be left holding the bag.

Sasseen is Washington bureau chief for BusinessWeek.