US Treasury credit deal to shore up Freddie and Fannie

The United States Treasury and The Federal Reserve announced measures to shore up Fannie Mae and Freddie Mac – the struggling government-sponsored companies that underpin the American mortgage market – in a bid to head off a potential meltdown in global financial markets.

In moves that could mean a major escalation in US taxpayer exposure, the Fed said yesterday that the companies could access its discount window for emergency cash. The Treasury also said it would temporarily increase its line of credit to the two, as well as purchase equity in them, if needed.

The Treasury Secretary, Hank Paulson, conceded last night that "we must take steps to address the current situation", adding that their "continued strength is important to maintaining confidence and stability in our financial system and our financial markets".

A senior Treasury official said all the actions it proposed need congressional approval, but expressed confidence that could be secured within this week.

The decision reversed an earlier statement by the Treasury Secretary that any rescue package for the struggling firms would have to come at the expense of the groups' shareholders.

Both companies had lost almost half their value last week after rumours of a state bailout swept the market and panicked investors into a mass sell-off.

Mr Paulson said policymakers had consulted closely over the weekend and added that it "makes sense" to take the actions announced. The Treasury would increase the line of credit to the companies, which currently stands at $2.25bn (£1.13bn), as well as offering them credit at the discount rate of 2.25 per cent from the emergency lending facility if needed.

Reports at the weekend had said that Mr Paulson was working on plans to inject $15bn into the companies – possibly before the markets opened in the US this morning. Under the terms of the proposal, the US government would issue a new class of shares, which would have diluted the position of existing shareholders.

Investors will be watching Freddie Mac as it attempts to get a $3bn debt sale away today. Failure to complete the sale could deal a heavy blow to investor confidence. However, it is believed that Treasury officials had been on the phone to investors over the weekend to ensure that the sale gets away without any trouble. Investors are still coming to terms with the failure of the Californian mortgage bank Indymac, which became the third biggest banking casualty in American history when it was seized by US regulators on Friday.

Savers with $100,000 or less in their accounts will have their savings fully guaranteed by the state. Those with larger amounts on deposit – around 10,000 customers – will now potentially lose some of their investment.

The collapse, which is expected to cost the Federal Deposit Insurance Corporation (FDIC) between $4bn and $8bn, is the biggest banking failure since the American Savings & Loan Association folded in 1988. The only other larger collapse was the Illinois National Bank, which folded with $40bn of assets, in 1984.

Indymac has assets of $32bn, and was ranked as the country's ninth-largest mortgage lender. It saw a sharp fall in its level of deposits last month, when the New York Senator Chuck Schumer raised concerns about the bank's solvency. Over the next fortnight, savers withdrew some $1.3bn – a move which the director of the US Office of Thrift Supervision, John Reich, blamed for the ultimate failure of the bank.

Sources said the bank's aggressive business model had also been to blame. The bank lent in the difficult sub-prime market, and had continued to lend aggressively since the start of the credit crunch in the hope of mopping up new business while its rivals were pulling back. Having been taken under the control of the FDIC on Friday, the bank will open for business again today.

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 a half a year ago.

Politicians attempted to calm the panic in the US banking sector at the weekend. Talking on CNN yesterday, Senator Christopher Dodd, who chairs the Senate Banking Committee, said: "They [Fannie Mae and Freddie Mac] have more than adequate capital, in fact more than the law requires ... They're in good shape."

This week promises to be another difficult one for financial markets, with Citigroup and Merrill Lynch both expected to unveil multibillion-dollar write-downs.

And Indymac may not be the last of the banking failures. Four small banks have already been closed. The FDIC has boosted its list of troubled banks to 90. Last year, just three banks failed.

"Indymac's takeover by the FDIC is one of many to come," predicted Daniel Alpert, an investment banker at Westwood Capital in New York.