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Why Should I Care?: Fannie Mae and Freddie Mac

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Like shooting finance in a barrel.

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Nervously, you wait, chewing through the last of your fingernails, for the loan officer to reemerge.

You've been here half the day already, wading through reams of paperwork - reading, disclosing, signing, initialing.

The words on the page lost their meaning hours ago. You just want to go home.

Given the daily barrage of bad news about the credit crunch, the mortgage crisis and failing banks, you'd think things would be a lot easier for someone who actually wants to take out a simple home loan.

As a matter of fact, just this morning you read an article about two mortgage companies, one with a name that sounds like what they call your grandmother at her retirement community, the other like some up-and-coming DJ. Fannie Mae (FNM) and Freddie Mac (FRE), could that be it? They ran out of money, apparently, which could make it even harder for you to get a mortgage in the future.

Harder? Is that some kind of cruel joke? How could taking out a mortgage be any more painful than it already is?

Fannie Mae and Freddie Mac, collectively referred to as the government-sponsored enterprises, or GSEs, account for roughly half the $10 to $12 trillion market for home loans in the U.S. Now that banks like Citigroup (C) and JPMorgan Chase (JPM) have their hands full with ugly balance sheets and the aforementioned crises, the GSEs fund around 80% of new mortgages.

The government established Fannie Mae in 1938 to promote affordable housing as part of the New Deal. In 1968, it ceased being a government initiative and became a private entity. Two years later, Washington gave birth to Freddie Mac, also publicly traded, to serve a similar function.

Because the GSEs were established by the government, it was assumed they would receive federal support if they ever got into trouble. This implicit guarantee allowed Fannie and Freddie to borrow and lend cheaply (more on this later).

The GSEs control a portion of the mortgage industry which rarely makes the headlines: The "conforming loans" market - loans made to borrowers with good credit and money in the bank.

Fannie and Freddie, being the adorable couple they are, buy these loans from banks, bundle them into packages and sell them to investors. These packages are called mortgage-backed securities. Investors (large institutions, foreign banks, hedge funds, you name it) who buy these bonds pay a fee to Fannie and Freddie for guaranteeing those loans.

Fannie and Freddie's primary role is to keep mortgage rates low by ensuring there will always be a willing buyer for those mortgages. As long as banks can easily sell new loans, they can offer low rates. If the loans become difficult to sell, however, banks are forced to assume more risk on each new loan they write - and to demand additional compensation in the form of higher interest rates.

Without GSEs, you'd probably be staring at a much higher rate and more superfluous, wallet-assaulting processing fees - in addition to all that paperwork.

But wait just one second. If Fannie and Freddie deal in only the safest of loans, why are they in trouble?

Well, it's like this: Due to lax regulation, easy-to-outwit automated risk systems and the assumption that their mortgage-backed securities came with a government guarantee, the GSEs were free to take on huge mortgage portfolios.

When home prices fell and borrowers of all kinds started defaulting, Fannie and Freddie found themselves running out of cash, facing mounting losses and without anybody foolish enough left to lend to them. That put them in dubious company (Countrywide, Bear Stearns and IndyMac (IMB), anyone?).

Finally, the loan officer's back. He's wearing a big smile and reaches out to shake your hand. The loan's approved, the wait's over. But you can't help but consider that, the next time around, in a world that may not include GSEs, it could be worse.

No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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