BEAR MARKET: Mortgage-backers Fannie Mae and Freddie Mac suffered a severe blow to their value this week—both stocks are at their lowest prices in 17 years. This pushed Wall Street into a bear market, or falling stock prices expected for an extended period of time.

For the third day in a row, Fannie Mae's stock price fell, down 28% since last Thursday. Freddie Mac lost 47% of its value in the past week and yesterday dropped more than any other stock on the Standard & Poor's 500. The fate of these two corporations directly affects how Americans will be able to obtain mortgages in the future.

Market Analysts Fear Under-Capitalization Could Destroy Mortgage Giants

The Federal National Mortgage Association (Fannie Mae) and Federal Home Loan and Mortgage Corporation (Freddie Mac) provide money for home mortgages. How? They buy residential mortgages and then package them as investments that they resell to investors.

Fannie Mae and Freddie Mac are the biggest mortgage backers in the country. Both companies are sponsored by the government, but held publicly.

Their strength—huge amounts of money to work with—is also their weakness—what if the money runs out?

This is the way it works.

1. You Get Mortgage: You get a mortgage from your local lending institution and buy a house.
2. Bank Lends Money: Your bank lends you the money at a low interest rate because Fannie Mae or Freddie Mac has said they'll buy the mortgage from your bank.
3. Freddie Mac and Fannie Mae Resell Mortgages: Freddie Mac and Fannie Mae buy lots of these mortgages and bundle them together, selling them as bonds paying a fixed interest rate.
4. Investors Buy Bonds: When the bonds come due, Freddie Mac or Fannie Mae forks over the principal plus interest to investors. The buyer makes money, Fannie Mae or Freddie Mac turns a profit and there's a pool of money to do more of the same.

Now, let's say you and millions of others stop paying your mortgages. Fannie Mae and Freddie Mac are out the price of the houses plus the interest, but they still have to pay the bondholders.

What happens then?

1. Can't Recoup: Housing prices have gone down, so Fannie Mae or Freddie Mac can't recoup the mortgages.
2. Loss of Capital: The result is a huge drain on Fannie Mae's and Freddie Mac's capital. If that capital runs out, then investors won't get their money back, which triggers more financial woes.
3. Sell Stock: Freddie Mac and Fannie Mae try to raise capital by selling more stock. This waters down the pool of investors, sends the value of the stock down and pretty soon no one buys it.

Backing Freddie Mac, Fannie Mae Would Increase National Debt by 50%

Both Fannie Mae and Freddie Mac are Government Sponsored Enterprises (GSEs). The federal government created them to make the American dream of owning a home come true for many families.

The Department of Housing and Urban Development (HUD) regulates the two companies, making sure they abide by the laws under which they were created.

The federal government doesn't own Fannie Mae and Freddie Mac—they are publicly traded companies that sell stock.

But the difference between the government implicitly or explicitly backing the two companies creates a bit of confusion:

• Because they are GSEs, they are implicitly backed by the government.
• Investors assume, rightly or wrongly, that the government will not let Fannie Mae or Freddie Mac default—this makes the stocks and bonds safe and a good investment.
• If the government explicitly backs them, then the taxpayers are responsible for any debt incurred by Freddie Mac and Fannie Mae.
• The two companies share $5 trillion of home mortgage debt.
• This would increase the national debt (currently at $9.5 trillion) by more than 50%.

Government Considers Options

The government is considering several ways to deal with the crisis:

• Give Fannie Mae and Freddie Mac a line of credit with the Federal Reserve.
• Make an equity investment in the companies.
• Promise to back their debt to the tune of $1.5 trillion.

Copyright © 2009 Informify

Question for Readers:

Do you think it is the responsibility of the government to step in and save Fannie Mae and Freddie Mac?