Fannie Freddie Freak Out: Part Two

Yesterday I talked about some of the basic facts about the two Government Sponsored Enterprises, mega-mortgage facilitators Fannie Mae and Freddie Mac. Today let’s turn our attention to the implications of the story—how does the bad behavior of your kooky old relatives, Fannie and Freddie, affect you?

The first question that comes to mind is, “What happens if either Fannie or Freddie were involved with my mortgage?” The answer is easy: NOTHING. Even if the government literally took over the two companies, which has not yet occurred, keep paying your monthly mortgage! In fact, paying your mortgage on time should always be your number one financial priority.

The more interesting question is what might happen to the general mortgage market for those who are interested in re-financing or those seeking a brand new mortgage? Without Fannie and Freddie, the market for mortgages would be even tougher than it is now. Together Fannie and Freddie have bought 80% of new mortgages in the US this year from banks and mortgage lenders -- losing that demand would be deadly for the already-beleaguered housing market, which is why the government is doing everything in its power to ensure that the companies continue to function.

But the whole thing is circular: when there are too many homes for sale, prices plunge, lowering the value of the assets on Fannie and Freddie’s balance sheet. With less capital available, the two kooks reduce the amount of lending activity or are forced to raise the cost of a loan. Concurrently, when prices fall, it leads to more foreclosures, as homeowners find it nearly impossible to refinance their existing mortgages. This “negative feedback loop” can build on itself and become a self-fulfilling nightmare, which throws the economy and the financial markets into disarray. (Conversely, some have estimated that if Fannie and Freddie were in stronger financial shape, mortgage rates could be lower by as much as a quarter of a point, helping to heal the housing markets.) This is why the government had to announce a plan to stop the bleeding.

On Sunday, the Bush administration asked Congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investments and loans. In a separate announcement, the Fed said that it would make one of its short-term lending programs, the so-called “discount window”, available to Fannie Mae and Freddie Mac. If these actions do not do the job, Fannie and Freddie could fall under the control of their government regulator, which would then be responsible for the firm. That step -- known as placing it in a “conservatorship” would allow the mortgage company to continue operating, but how efficiently is unknown. Clearly, this would be a last resort for the government.

For those who want “someone to pay”, don’t worry: shareholders of the two companies have lost approximately 80% of the value of their investments this year alone. I don’t know about you, but that does not make me feel too good in this environment.