Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) have been placed in conservership by the U.S. Government after Treasury officials determined that the two entities had major structural flaws and that its officials’ use of accounting methods had overstated the value of its capital base or capital cushion. A conservator is defined as a public official or institution that is charged with taking over an individual or institution that cannot manage its affairs satisfactorily— in some cases, due to incompetence.

Morgan Stanley, retained as an outside auditor by the Treasury Department, determined the financial findings for the department. Officials reported that Freddie Mac had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of this year—in order to avoid disclosing such losses until early 2009. Fannie Mae has used similar methods during the reporting of their financial conditions. Both companies have the option of challenging the conservatorship, and could seek a judicial review; however it is highly unlikely.

A History of Problematic Accounting and Reporting

Accusations of improper accounting are not new for either Fannie Mae or Freddie Mac. In the past 10 years, both companies paid large fines to regulators and replaced their top management executives after accounting scandals. Although federal regulators have had a watch on the firms, it is thought that no significant action had been taken to curtail these practices. No new reports of improper accounting charges have surfaced in the news or have been issued by the Treasury Department with this action.

A growing concern among foreign investors was that the companies’ debt might not be repaid. According to federal regulators, the continued downward spiral of home prices– expected to lead to even more mortgage defaults among the mortgages held or guaranteed by Fannie Mae and Freddie Mac — have contributed to the government’s aggressive actions. Combined, the two institutions own or back $5.3 trillion in mortgages, which represent approximately 50% of U.S. mortgages. Much of Fannie Mae’s and Freddie Mac’s efforts to buy and back U.S. mortgages free up financial institutions and banks with money to make new loans, a vital function that drives the market. It is expected that due to the Treasury Department’s intervention, the cost of borrowing from Fannie Mae and Freddie Mac may decline; the government will be standing behind their debts. This situation has been well-publicized for over a month due to Congresses’ previous efforts, yet has not stopped credit or financial market insecurities. From an operational aspect, the buying and selling of loans will continue.

The downward spiral of home values, and the existing problematic nature of the housing industry is another matter that the bailout likely will not affect. Foreclosures are almost certain to continue to rise.

Use of Tax Payer Funds

The move under the direction of Secretary of the Treasury Henry Paulson is to use taxpayer funds to pay any losses or defaults on mortgages that the two institutions have guaranteed. The exposure could be as much as $800 billion, and represent the biggest transfer of tax dollars to bail out bad lending in U.S. history. As opposed to providing a singular upfront cash infusion, the Treasury is expected to inject cash into the companies on a quarterly basis and evaluate their positions carefully. Daniel Mudd, Fannie Mae’s CEO, and Richard Syron, Freddie Mac’s CEO, were terminated and the board of directors of both entities were replaced. It is unclear as to whether any severance packages were agreed upon.

Secretary Paulson had obtained authority from Congress to utilize taxpayer funds for such an effort in 2008. The authority alone however failed to alleviate investor and market anxiety of world financial markets and global investors. In particular it failed to affect those in China– which owns $340 billion of Fannie and Freddie mortgage-backed securities and billions of dollars in mortgages from assets in the U.S. This move, effectively pulling the trigger on the authority, may yield positive results.

Stock Market Performance

Both entities common stock value has plunged significantly for the past ten months. Even news of the U.S. Congress backing last month did not provide a much needed lift in the markets. Investors who own the companies’ common market-traded stock will lose all value. Preferred shareholders, who have priority over other shareholders, are also expected to be paid little. Holders of debt, including many foreign central banks, are expected to receive government backing.

Stock Prices in the Last Three Years

Initial Global market Reaction to the news has been positive.

The markets in Europe and Asia reacted positively to the move of the takeover over the weekend as stocks rose. In Europe, a bank identified as being one of the largest exposed by the sub-prime mortgage lending crisis, UBS AG, saw its stock rise nearly 12 percent. Mizuho, one of the largest lenders of assets in Asia, reacted to the news with a 12 percent jump as well. Citigroup, the biggest U.S. bank by assets, climbed 5.9 percent to $20.20. JPMorgan Chase & Co., the third-largest, increased 2.6 percent to $40.62 in Germany.

The beginning of the end?

Many international trading and management firms are hoping that the move by the U.S. Government is the beginning of the end of the problem that has spread globally due to the packaging and selling of mortgages to global investors. Losses have been estimated at $17 trillion in global equity in the past 11 months due to writedowns and losses.

As the sub-prime problem has reverberated, the problem has caused global financial weakness in the credit markets around the world with fears of the failure of large financial institutions. The fact that the U.S. Treasury has acted in an aggressive manner may demonstrate its leadership role in financial markets– albeit worry over the impending doom of the two organizations has not dissipated. U.S. Treasury officials hope that the move will help remove excessive uncertainty out of the market in one quick move.

At the end of the day, the U.S. Treasury move on Fannie Mae and Freddie Mac has been designed to restore investor confidence in the U.S. credit markets, appease foreign debt holders, help stabilize the stock market, and keep loans and funds flowing to creditworthy borrowers. While very early results had been positive, time and constant analysis of market performance, along with capital and credit availability will provide the true measure.