• Cover Story
• Table of
  Contents
• Contents By
  Topic
• Columns
  • Brownstein
  • Cook
  • Crook
  • Powers
  • Rauch
  • Stokes
  • Schneider
  • Taylor Jr.
• Regular
  Features
  • Hotline Extra
  • Inside Washington
  • Insiders Poll
  • K Street Corridor
  • People
  • The Week on the Hill

From The ArchivesHow Did We Get Here?Read about what National Journal reported on Fannie Mae and Freddie Mac before the mortgage crisis.




May 27, 2005
• Taking Cover
• In Frannie's & Freddie's Shadow

May 12, 2000
• Siblings Fat & Sassy
• Q&A With Franklin Raines
• Q&A With Rep. Richard Baker

The Bush administration proposed a rescue plan for lenders Fannie Mae and Freddie Mac this week, as shares in the mortgage giants dipped dangerously close to insolvency. Here's a guide to what's going on.

Please tell me again--why are Fannie Mae and Freddie Mac so important? What do they do?

The Federal National Mortgage Association (known as Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac) do a few things that add up to dominate the $12 trillion market for home loans. Their basic role is to act as an insurance company for home loans made by banks, agreeing to pay off the (once-tiny, now not-so-tiny) percentage of mortgages on which homeowners default. Like an insurance company, Fannie and Freddie spread risk, and the costs of risk, by bundling together large numbers of loans. For different reasons--including a desire to make money--they also end up directly owning a lot of mortgages. This has helped to stabilize markets in normal times, but now it is adding to their losses.

Do Fannie and Freddie do the same thing?

Pretty much. Freddie Mac was created to end Fannie Mae's monopoly in guaranteeing home mortgages. They are both private companies whose shares are traded on the New York Stock Exchange.

What would happen if they disappeared or were severely impaired?

Even the lenders' harshest critics say that their demise is unthinkable in the near term. The two either own or guarantee half of all home mortgages--including three-quarters of those issued in the last year or so. If they went under, most would-be borrowers would not be able to buy a home, and that would wipe out the wealth of most Americans.

Moreover, banks and other corporations, which own many of the securities created by Fannie and Freddie, would suffer huge losses, be unable to borrow money, and have to lay off many, many workers. The economic effects would be global because Fannie and Freddie securities are traded nearly as widely as are Treasury bills.

In fact, even a short-term disruption in Fannie's and Freddie's business would threaten a worldwide financial crisis. Consider this: The Federal Reserve Board took unprecedented action to prop up the Wall Street investment firm Bear Stearns out of concern that its failure could cripple the global economy. Fannie and Freddie combined are 10 times the size of Bear Stearns, in terms of their transactions.

But Fannie and Freddie have always had the guarantee of a government bailout, right?

In effect, yes. Since the lenders converted from government agencies to so-called government-sponsored enterprises in 1968, federal officials have never made an explicit guarantee. Investors have nevertheless always assumed such a promise, allowing Fannie and Freddie to borrow money more cheaply than independent banks.

And the implicit guarantee encouraged reckless management?

That is one way of looking at it. CEOs don't need encouragement to take risks in pursuit of profits--that is what they do. But without the backstop of a possible Treasury bailout, the companies' stock prices would have been lower, reflecting the full risk of bankruptcy. Likewise, when Fannie and Freddie were caught pulling accounting tricks a few years ago, their share prices didn't collapse, as they might have for other companies. Investors figured that Uncle Sam was on the hook for the money.

But was it bad management that caused Fannie's and Freddie's stock prices to plunge?

Not really. Since both companies threw out their chief executives and restated their earnings a few years ago, they have, by most accounts, acted responsibly. Fannie and Freddie were under strict limits for lending money until February, when the mortgage market had slowed considerably. In line with many other mortgage stocks, by early May theirs fell about halfway from their recent high. Their costs for borrowing rose but were still lower than for any other private company, and the pair had no trouble raising money. Fannie and Freddie were more exposed to the housing downturn than other companies, but not because of risky lending to unworthy borrowers.

So, what happened?

Investors had good reasons to expect things to get worse, but not this quickly. In the last few weeks, Fannie and Freddie seem to have been at least partly the victims of speculative investors who decided to bet on their downfall. When a lot of investors join in the betting, they can effectively bring the downfall about. Just such speculative "short-selling" helped to turn Bear Stearns's cash shortage into a catastrophe.

Aren't there rules against that kind of manipulation?

Sort of, but not really. Without evidence of coordinated manipulation, the existing rules make it hard for government regulators to act against efforts to drive down a stock. That's why the Securities and Exchange Commission took emergency action this week to specifically target short-selling of Fannie's and Freddie's stock.

Didn't the Treasury secretary say that the government was not offering a bailout?

Secretary Henry Paulson Jr. was contesting a semantic point that experts argue during every bailout. In truth, Treasury's promise to lend Fannie and Freddie money is the bailout, and it hopefully lowers the ultimate cost of, or even eliminates the need for, spending taxpayer money to prop up the companies. That is, at least, what Paulson hopes will happen.

Doesn't the bailout, by whatever name, need congressional approval?

Under its existing authority, the Federal Reserve Board said it would make loans available for (probably) up to 30 days at below-market rates to help Fannie and Freddie deal with any cash shortages. Congress would have to authorize the two major prongs of the Treasury Department's proposed role. First, Treasury wants the OK to lend money directly to Fannie and Freddie, which together have about $1.6 trillion in debt on their books.

Wait, how much lending are we talking about?

As of July 16, Paulson was refusing to commit to a limit, arguing that it would allow speculators to manipulate the process. But his aides didn't dispute reports that Treasury is talking about a limit of $300 billion.

The second part of the plan would allow Treasury, if need be, to take a noncontrolling equity stake in the companies, to help prop up their stock prices.

What about "conservatorship"?

Under existing law, the Housing and Urban Affairs Department can effectively take control of Fannie and Freddie if they are "critically undercapitalized." Such a move would effectively wipe out the value of their stock (which presumably wouldn't be worth much at that point anyway). Treasury officials say they want to avoid this takeover.

How low would the stock have to fall before HUD would act?

It is a guess, but probably somewhere below $2 a share. On Tuesday, Fannie's stock fell to about $7 and Freddie's hit $5.26, before rebounding a bit on Wednesday. In October, Fannie was trading for $67 a share and Freddie was at $63.

Some Republican leaders are skeptical and are calling for hearings on Treasury's proposals. How likely is Congress to approve the proposals, and how quickly?

It all depends on whether, and how rapidly, things get worse for Fannie and Freddie. If their stock prices stabilize, Congress could alter the terms of the bailout. After all, lawmakers have been chewing over legislation to revamp regulation for Fannie and Freddie for the past six months. But if the mortgage giants' stocks tank and the pair are close to bankruptcy, congressional Republicans would probably want to avoid taking the blame for a botched rescue effort.

In the end, then, Treasury could take over Fannie and Freddie, or become a major shareholder. It could lend them hundreds of billions of taxpayer dollars. The Fed might be on the hook as well. And the SEC is issuing new rules. Is this as big a shift in governance as it seems?

Too early to say. A similarly large government bailout of the savings and loan industry 20 years ago ushered in a broad deregulation of banking. Paulson is improvising in a crisis. Even the presidential candidates are talking cautiously. If the crisis recedes quickly, Washington could engage in a real debate about the longer-term role of government in the mortgage sector, but right now everyone has plenty of incentive to avoid one.

Is there a tie between Fannie and Freddie's problems and that California bank that the government took over?

Not directly, just that IndyMac Bank was hurt by the same downturn in the housing market that's weighing down Fannie and Freddie. Of course, the money to rescue IndyMac is coming from the same source that would fund a Fannie-Freddie bailout--taxpayers. Rescuing IndyMac will cost the Federal Deposit Insurance Corporation $4 billion to $8 billion. A bailout of Fannie and Freddie would help avoid much larger bank failures that could easily run through the $53 billion that the FDIC has on hand to pay for bank takeovers.