Video: Why do Fannie and Freddie matter?

By John W. Schoen Senior producer
updated 7/12/2008 8:00:56 PM ET 2008-07-13T00:00:56

The collapse of Fannie Mae and Freddie Mac shares came suddenly this week, as investors fled the two mortgage finance giants over worries they may not have the financial strength to weather the ongoing storm in the housing market. But the problems facing Fannie and Freddie have been building for years.

Those financial problems could, in turn, push the housing market into a deeper decline. The two government-sponsored mortgage companies, which hold a staggering $5 trillion in mortgages and mortgage-backed paper, have emerged as the primary source of funds for home buyers following the meltdown of the subprime mortgage industry.

“Investors have lost total confidence in Fannie and Freddie and are looking for a government bailout,” said Robert Napoli, an analyst who follows the financial services industry at Piper Jaffray. “If Fannie and Freddie have to pull back substantially in their lending, we're taking another leg down in the market and housing prices. There are no other lenders right now in the U.S. mortgage market other than Fannie and Freddie."

The companies, which are nominally private but operate under government charters, buy up mortgages written by other lenders and sell them to investors, freeing up more capital for new loans. With the downturn in the banking industry and the collapse of many lenders, Fannie and Freddie are critical to any prospects for recovery in the U.S. housing market, which is mired in its worst downturn since the Great Depression.

Fears about the fate of the two mortgage lending giants swept through financial markets Friday after published reports that the government was considering a bailout. Shares of big commercial and investment banks also took a hit on worries about the prospect of further losses and writedowns.

Treasury Secretary Henry Paulson sought to calm the markets by saying that the administration's "primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission." That helped boost Fannie and Freddie shares off their lows, although both were still down in late trading.

Fannie Mae shares have lost 80 percent of their value over the past year, while Freddie Mac shares are down 90 percent.

There are several steps the government could take short of a takeover of the two mortgage finance giants. The Federal Reserve could extend credit and promise to stand behind the two companies if they run short of cash — just as the central bank did in March when it engineered the takeover of Bear Stearns. The Treasury also could buy up mortgage-backed securities issued by Fannie and Freddie to shore up that market.

Established in 1938 as part of President Franklin Roosevelt’s New Deal, Fannie Mae was created to get the mortgage market moving again after credit for home buyers dried up during the Great Depression.

Though it gets no federal funding or explicit guarantees, investors have always assumed the government would make good on its debts if it ever got into financial trouble. That implicit guarantee has helped hold down interest rates on bonds issue by Fannie Mae and thus has helped hold down mortgage rates.

Freddie Mac, which operates under similar government charter, was set up in 1970 to expand funding for the U.S. mortgage market.

Major Market Indices

Concerns about the financial strength of the two entities have been building since the mortgage market began unwinding more than a year ago. Those worries intensified this week after a report that a possible change in accounting rules could force Fannie and Freddie to raise another $75 billion in capital. If they raised that capital by selling stock, that would dilute the value of shares already held by investors. 

Regulators insist that Fannie and Freddie have enough cash to weather the storm. But with foreclosures running 50 percent higher than a year ago, and home prices still falling, it’s hard to know just how badly their mortgage portfolios will be hit.

So far the two companies have reported losses of $11 billion on their $5 trillion in mortgages and related securities. And while the default rate on mortgages written after 2005 have been higher than normal, most of the rest of the mortgages held by Fannie and Freddie are performing well.

But investor worries already are raising the cost for Fannie and Freddie to borrow money, which in turn makes mortgage more expensive.

“We're spiraling downward and revaluing the balance sheet as we go there, and in a sense the pessimism is creating a less viable Fannie and Freddie," said Paul Kedrosky, a market strategist with Ten Asset Management. “If you want to be a rationalist about this, the bailout doesn't need to happen. The trouble is the emotional component.”

Video: Uncertainty over Freddie-Fannie fallout The problems at Fannie Mae and Freddie Mac predate the recent mortgage meltdown, and efforts to strengthen their financial base have been under way for years. Congress has been debating reform of the entities since 2003, but those efforts have been stalled for a variety of reasons.

Passage of one proposal on a new regulator for the companies has been delayed by debates about whether to limit the size of their portfolios and their broader mission. A 2005 accounting scandal at Fannie Mae, which cost top executives their jobs, also set back efforts.

More recently, reform efforts have been stalled by debate over a housing relief bill, which the Senate was set to vote on Friday afternoon.

As mortgage defaults and foreclosures have risen, Congress and the White House have been split on the issue of providing tax-funded assistance to ease the impact on homeowners and communities. Opponents of broad relief measures have argued against a “bailout” of imprudent lenders and borrowers; proponents have argued that the Fed already has stepped in to bail out the banking industry.

Further delays will only make matters worse, according to James Paulsen, chief investment strategist at Well Capital Management.

“I think at the moment what scares me the most is just the limbo we're in here,” he said. “Creating uncertainty as we debate about it, we make it worse, and there's no nimble Fed that can just step in and change this or make a quick decision to extinguish this situation even if we wipe out the shareholders. It's like the longer we talk about it, the more it spreads out across the market.”

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