Fannie, Freddie must not be allowed to fail: Poole

Former Federal Reserve Bank of St Louis President William Poole participates in a Bank of Korea seminar in Seoul June 16, 2006.

WASHINGTON (Reuters) - Fannie Mae and Freddie Mac are too big to fail and must be kept alive to avoid a crisis of "unspeakable magnitude," a former top Federal Reserve policy-maker said on Friday.

"Clearly they must be supported. They (the U.S. government) cannot allow that amount of assets ... to go into limbo," said William Poole, former president of the Federal Reserve Bank of St. Louis, who retired at the end of March.

"It would produce a worldwide financial crisis of unspeakable magnitude if they were allowed to default," Poole, a long-time critic of the government-sponsored mortgage institutions, told Reuters in an interview.

Fannie Mae and Freddie Mac own or guarantee $5 trillion of debt, almost half of all U.S. mortgages. Their shares have tumbled on fears they might run short of capital, spawning speculation of a government bailout.

A newspaper article floating the prospect of a government takeover forced U.S. Treasury Secretary Henry Paulson earlier on Friday to issue a statement stressing that he was committed to backing Fannie and Freddie in their current form.

Paulson also said that he was supporting them as they took the "steps necessary to allow them to continue to perform their important public mission".

One option could be throwing them a lifeline to the Fed's discount window for emergency cash, echoing action taken by the Fed to help rescue U.S. investment bank Bear Stearns when it nearly collapsed in March.

Poole, a 10-year Fed veteran, said the U.S. central bank would probably have the authority to open the discount window to Fannie and Freddie under the "unusual and exigent" circumstances it invoked back in March, when discount window privileges were extended to other investment banks.

But he did not think such a drastic step would be necessary, noting that the Fed could simply purchase the GSEs' debt directly and hold it on the Federal Reserve system's open market portfolio.

The Fed used to do this as part of the normal course of its business as recently as the 1990s.

Poole, who stressed he was speaking purely on the basis of his general knowledge of the Fed and said he was not privy to current discussions, made plain that he felt that any direct support from the Fed should be short-lived.

"I'd assume that the Fed would only be willing to take those obligations as part of a temporary solution," he said.

Poole has long argued for a reduction of government support for Fannie and Freddie, saying they unfairly enjoy an implicit government guarantee and presciently warning that they posed a systemic risk because of their vast size.

He said that based purely on its own public accounts, Freddie Mac was insolvent on a fair-value basis. But he stressed that he did not think that either it or Fannie Mae would ever become actually insolvent, meaning they were unable to pay their bills.

"I don't believe either one will ever be insolvent in terms of meeting its obligations," because the market will be confident of government support and will keep credit flowing, Poole said. "That is what Bear Stearns could not do."

The most likely solution, in Poole's view, was the eventual nationalization of Fannie Mae -- something that he has advocated in the past.

"For years I argued about the dangers of the situation that is developing now; urging that they expose themselves to more market discipline and ... build capital. It didn't happen, and now we are where we are," he said.

(Editing by Andrea Ricci)