Crisis at Fannie Mae and Freddie Mac

The past week has been tumultous for the giant US mortgage finance firms - Fannie Mae and Freddie Mac. With home foreclosures rising, mortgage holders defaulting in ever larger numbers, and home prices falling steeply, the two major firms are left holding increasing quantities of worthless paper. In 2008, till date the shares of the former have plummeted 74% to $10.25, while that of the later has dived 77%, closing at $7.75. So far, they have lost more than $11bn in the sub-prime mortgage crisis.

Combined, these two shareholder owned companies guarantee or own more than $5 trillion in home mortgages, almost half the nation's $12 trillion mortgage market. At a time when the sub-prime mortgage is continuing to unravel, any serious trouble with these two morgage finance firms will reverberate across the financial markets.

While originally formed by the Government to supply liquidity to the mortgage market, both have subsequently become private shareholder companies. However, the government origins and the massive size of these two firms continues to give the widespread impression that they are government backed and hence cannot fail. This in turn means that they get capital at much lower cost than their competitors. Further, they also were not subjected to the same levels of oversight and did not have to meet the regular capital adequacy requirements, other financial standards and tax burdens.

Contrary to popular perception, neither Fannie Mae nor Freddie Mac make any home loans. They take in mortgage loans from banks by charging a guarantee fee for the risk it is undertaking, pools and repackages them in the form of mortgage-backed securities (MBS), and then sells them to investors in the open market, with a repayment guarantee. There are limits on the types and size of loans it can guarantee. Both also borrows money from the debt markets, traditionally at a rate much lower than other banks, and uses it to buy mortgages it holds as its own investments. By buying these loans, Fannie injects new money into the housing economy.

By taking on the mortgage loan risk, Fannie and Freddie provide stability and liquidity to the mortgage market, and allows banks to make even more mortgages. If it is harder for them to borrow money, mortgage interest rates will rise. If Fannie and Freddie stop buying loans, banks may stop making new loans, freezing the United States housing market.

Virtually every Wall Street bank and many overseas financial institutions, central banks and investors do business with Fannie and Freddie. The Wall Street banks have reaped rich fees by issuing debt for them. The consequences of a contagion effect on the entire financial system could be devastating.

Ironically, as Fannie Mae and Freddie Mac have grown in size and taken in more and more risk, they have also succeeded in transferring those risks to the entire financial system. Given their size and depth, it has become a fait accompli that the Government will step in and bail them out if problems become severe. As the saying goes, "If you owe a bank $100, then you have a problem. But if you owe the bank $100 million, then the bank has a problem"! Much the same applies to Fannie Mae and Freddie Mac today!

Update 1
Paul Krugman believes that it is inevitable that Fannie Mae and Freddie Mac will be bailed out, as the economy cannot afford them to fail.