By John W. Schoen Senior producer
updated 9/2/2008 8:06:57 AM ET 2008-09-02T12:06:57

The latest worry in the ongoing mortgage mess concerns the fate of mortgage giants Fannie Mae and Freddie Mac. But if most mortgages are being paid on time, just what is everyone so worried about?

Why is everyone so worried about Fannie and Freddie? I have read that the percent of bad debt is very low and that over 85 percent of the mortgages are low-risk. So can you please explain why this is such a big deal in plain language?
Jim E., Chesapeake, Va.

The fate of Fannie Mae and Freddie Mac is a big deal because these two mortgage companies have gotten so big. Between the two of them, they are involved in something like $5 trillion worth of mortgages — about half the mortgages in the U.S. The total is about the same as the entire amount of Treasury debt in the hands of investors, governments and other public holders. It's a big number.

It's true that most mortgages in Freddie and Fannie's portfolios are in good shape. The problem is that the two companies have an extremely thin cushion of capital to fall back on at a time when more and more loans are going bad.

Fannie and Freddie were set up to buy up mortgages from lenders, freeing more cash for those lenders to write more mortgages. Over the years, Fannie and Freddie’s friends on Capitol Hill have allowed them them keep a much smaller reserve on hand than those other lenders. Critics have been saying for years that Fannie and Freddie needed to build a bigger cushion for bad times, but they have largely managed to avoid doing so.

Losses from bad loans have chewed up $11 billion of Fannie and Freddie's reserves in the past year — and they're expected to lose billions more. That has left them with about $80 billion in capital to cover possible defaults on their $5 trillion in mortgages, a ratio of only 1.6 percent.

With defaults and foreclosures rising, that doesn't look like it's going to be nearly enough to tide them over until the housing market stabilizes. The big problem is that no one knows how many more homeowners will default in coming months.

The delinquency rate on all mortgages jumped to 6.35 percent in the first quarter — from 5.82 percent in the fourth quarter of last year, according to the Mortgage Bankers Association. Delinquencies occur when homeowners fall behind on monthly payments and often are followed by defaults.

Though Fannie and Freddie have no explicit backing by the federal government, it has always been assumed that Uncle Sam will come to their rescue if they get into trouble. That lowers the borrowing costs for the two companies and, in theory, for home buyers. Uncertainty about Freddie and Fannie's future has already raised those borrowing costs, which makes it more expensive to take out a mortgage. That’s not exactly what the housing market needs at the moment.

There are a number of scenarios being discussed to bail out these two mortgage giants, including having the Treasury buy up some of the loans on their books. Another option would be for the government to provide a big chunk of capital — for which it would likely demand stock.

That could turn out to be bad news for Fannie and Freddie's shareholders — who have already lost 80 percent of their investment as the mortgage giants' shares have dropped over the past year. If the companies issue more shares to the government it will dilute the holdings of existing shareholders, pushing down the price further.

If you don't hold Fannie or Freddie shares, you may wonder why that matters to you. The answer is that a large chunk of Freddie and Fannie stock is held by the nation's banks, which are already suffering from the rise in bad loans and the credit crunch. The last thing they need right now is to lose more money on their Freddie and Fannie shares.

Whatever the outcome, the longer it takes to come up with a solution, the bigger the problem will get. It's pretty clear that the government can't let these two companies run out of cash: A default on their obligations would touch off another earthquake in an already fragile financial system. Over time, Freddie and Fannie may become much smaller players in the mortgage market — there are plenty of other lenders and sources of capital out there.

But lenders and investors are so spooked these days by the continued losses from commercial and investment banks — and the ongoing slide in house prices — that they're reluctant to get into the mortgage market just yet.

So until home prices bottom out, and banks and investment firms stop reporting big losses every three months, Fannie and Freddie are pretty much the lenders of last resort to provide the money needed to keep the mortgage market funded.

Are mutual fund holders safe if the investment banks that run the funds go under?
— Bill, Atlanta, Ga.

Generally, yes — the odds of losing money this way are pretty remote.

A mutual fund is more than just a pooled account holding a portfolio of stocks or bonds. Each fund is set up as an investment company, governed by rules and regulations enacted to protect mutual fund investors. While the assets are managed by an investment adviser — who may be hired by an investment bank — the holdings are kept in a separate trust or corporation at a custodial bank. So they're not part of the investment bank's assets: If the bank runs into trouble, it can't use the mutual fund holdings to offset losses from other businesses.

But keep in mind that the investment bank selling mutual funds makes its money charging management fees. With profits squeezed, it may look for ways of increasing those fees. It's always a good idea to keep a close watch on what you're being charged. One or two percent may not seem like much, but over the life of your investment it makes a big difference.

The other way you may be covered is through the Securities Investor Protection Corp. or SIPC. This federal agency protects assets held by member brokerage companies — much like the FDIC insures deposits in savings banks.

If the brokerage or investment bank holding your stocks or mutual fund shares goes bust, the SIPC steps in and makes sure you get back your investments. The SIPC does not protect against financial fraud, however.

Of course, there are no protections for investors who lose money because the fund manager made bad investment decisions. Of all the risks involved in mutual fund investing, "management risk" is probably the hardest to protect against.

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