Monday, September 15, 2008

The Basics on Fannie and Freddie and What Happened

What are Fannie Mae and Freddie Mac?
They are called government-sponsored enterprises because they initially were formed by the federal government. Fannie Mae is a common name for Federal National Mortgage Assoc. in Washington, D.C. Freddie Mac is a common name for Federal Home Loan Mortgage Corp. in McLean, Va.

What do Fannie Mae and Freddie Mac do?
Fannie Mae and Freddie Mac buy mortgages from savings and loans, banks and other lenders to generate more cash for those lenders to make more home loans. Together they hold or guarantee $5.4 trillion of mortgages, about half of the US's outstanding home loans.

What happened?
As home prices fell, foreclosures went up, and lenders ran into trouble, so did Fannie and Freddie. Loans they backed went bad, capital became harder to come by and it was harder for Fannie Mae and Freddie Mac to sell their loan packages. Thus, like any desperate, compromising soul, they lowered their standards and backed riskier mortgages and all this came back to bite them.

What effect on mortgage rates?
Like many Americans having trouble selling their homes, Fannie and Freddie have been having trouble selling their packages of loans. The investors who typically buy from them have become much pickier about what they’ll buy - with good reason - they were worried about increased risk as mortgage defaults rose and home prices fell. Since the two companies own or insure about $5 trillion in mortgages (nearly half of the nation’s total), the world has been watching them very carefully. Especially the American government.

In the opinion of the government leaders, Fannie & Freddie were headed toward failure. Since they’re so big, their failure would have dramatic (likely worldwide) consequences. So Uncle Sam officially stepped in.

So why are mortgage rates falling now? Fannie and Freddie are like big insurance companies. Before the federal bailout, investors worried that Fannie or Freddie might not be around to pay if mortgages they bought went sour. Worried investors = high mortgage rates for consumers. Now that Uncle Sam has stepped in, mortgage bond holders feel much safer. Happy investors = lower mortgage rates for consumers.

Who are the losers?
Us, the American taxpayers. This bailout is not free. No one knows the final damage this bailout will do to the Treasury, but most believe that the losses will be in the hundreds of billions. Considering that Fannie and Freddie holds approximately $5 trillion in home loans and currently more than 9% of loans are in the process of defaulting, then simple math tells us that these two companies could potentially lose $450 billion. Additionally, taxpayers will have to pay for the upkeep and operations of these companies so the costs will keep on increasing for years to come.

Who are the winners?
Banks that invested in Fannie and Freddie's debt. Fannie and Freddie sold trillions of dollars in mortgaged backed securities to central banks all around the world. For example, China's People's Bank owns more than $300 billion in Fannie and Freddie's mortgage backed securities. If both of these companies defaulted on all of these securites the Chinese national bank may have gone bankrupt.

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