Credit Crunch: Fannie and Freddie Rescued By Government Loan

An emergency plan by the US government to stabilize the nation's two biggest mortgage finance corporations proved sufficient to calm fears of imminent collapse yesterday, but Wall Street was gripped by a fresh flurry of alarm over possible failures of regional banks.

After a weekend of frenetic activity, the US treasury is seeking approval from Congress to lend billions of dollars of extra funds to Fannie Mae and Freddie Mac and, if necessary, to use taxpayers' money to buy shares in the embattled companies.

The intervention bolstered confidence enough for Freddie Mac to complete a scheduled $3bn (£1.5bn) auction of debt yesterday. Executives at Fannie and Freddie insisted it was "business as usual" and that the auction had been oversubscribed.

The Dow Jones Industrial Average initially rose by more than 100 points before tumbling on rumors of problems at two major banks - the Ohio-based National City Corporation and the Seattle-based Washington Mutual. The blue-chip index closed down 45 points at 11,055.

Democrats said they would support the government's support package for Fannie and Freddie, which is likely to be tacked on to a housing bill and rushed through Congress this week. Christopher Dodd, chairman of the Senate banking committee, said he believed Fannie and Freddie were "very solid" institutions, but that regulatory oversight had been lax. "The problem we're looking at did not have to exist had there been appropriate regulation," said Dodd. "We're in this mess because people who should have been doing a better job were not doing it."

The Republican presidential candidate, John McCain, said the actions were "correct" and would "preserve the ability of Americans to obtain loans in order to buy a home and be able to afford mortgage payments they're having to make".

In effect a federal guarantee, the package is a reversal of years of insistence by the US treasury that Fannie and Freddie were private enterprises that stood or fell on their own. Abby Joseph Cohen, a senior US investment strategist at Goldman Sachs, said: "To calm the markets at this point was their number-one goal and, at least thus far, they've been successful."

Fannie and Freddie back some $5.3 trillion of mortgage debt, accounting for half of all US home loans, and analysts say that a failure of either would be catastrophic. In a research note, Barclays Capital said they were "so intertwined in the fabric of global capital markets that a failure would cause not just a US recession, but a global depression".

But as confidence returned in the two firms' survival prospects, there were signs of panic selling elsewhere as concern gripped investors about the health of regional banks which have become ensnared in the sub-prime mortgage crisis.

National City's shares dived by 48%, forcing it to request a suspension in trading and to issue a statement denying that it was suffering a run on deposits. Hours later, Washington Mutual's stock dived by 35% following a negative note from a banking analyst at Lehman Brothers. The Seattle bank, known as WaMu, responded that it was "well capitalized" and had excess funds of more than $40bn.

The plunges came in the wake of regulators' seizure of IndyMac Bancorp, a Californian bank which suffered a run on deposits last week. Hundreds of customers queued outside branches yesterday in scenes reminiscent of Britain's Northern Rock crisis, with some arriving at the bank's Pasadena head office branch as early as 4am.

As the authorities are increasingly obliged to intervene in failing institutions, there are calls for a broader rethink of regulations surrounding the risks taken by banks. Lawrence White, an economics professor at New York University's Stern business school, said the Federal Reserve's decision to open its lending "discount window" to institutions begged fundamental questions. "We as a polity need to figure out, especially for investment banks, what kind of prudential regulation is going to go along with this lending regime."