Under new management: Freddie Mac and Fannie Mae

A lot of people saw it coming... and wondered why the powers that be at Freddie Mac and Fannie Mae didn't. Between the two finance companies, they hold or guarantee about 50 percent of mortgage debt in the United States, worth around $5 trillion. On Sunday, September 7th, the government seized control of both companies in an effort to stabilize them, and more importantly, to protect homeowners whose mortgages are owned by them.

Washington-based Fannie Mae was started back in 1938 under Franklin Roosevelt as a way to expand the flow of mortgage funds to all borrowers in all communities, and to keep houses affordable. In 1968 Congress rechartered Fannie Mae as a shareholder-owned company funded by private capital, from domestic and foreign sources. In 1970, Virginia-based Freddie Mac was formed to provide competition for Fannie Mae.

Though they are both private companies, they have always operated with government oversight, making them a sort of hybrid between public and private agencies. Once considered the source of the safest loans, since the housing market started on its downward path Fannie Mae and Freddie Mac have endured billions in losses.

A couple of years ago, other lenders were going belly-up after making loans to riskier borrowers and letting those borrowers overextend themselves. But Fannie Mae and Freddie Mac were still backing 30 year fixed loans with 20 percent down. More recently, they began lowering their standards, making Alt-A loans* to people with generally adequate credit but little or no proof of income.

Those Alt-A loans –- concentrated in high speculation areas of California, Nevada, Arizona, and Florida –- make up 10 percent of Freddie Mac and Fannie Mae portfolios, but account for more than 50 percent of their credit losses. As housing prices in key cities like Las Vegas, Los Angeles, Miami, and Phoenix tumbled, the value of the mortgages that make up the assets on the books of finance companies also plummeted. As foreclosures have occurred, mortgage holders have been able to recover less money.

Industry analysts suggest that the sibling companies, along with many others, took advantage of the perception that the government would not let them fail. In a sort of financial orgy, they amassed profits, but also took on too much risk, causing investors to lose faith in them.

Freddie Mac and Fannie Mae have been raising money through debt sales, but as nervous investors pull back, the figures have been disappointing. China -- the largest foreign holder of Freddie Mac and Fannie Mae debt –- has reduced its U.S. portfolios by about 25 percent since late June.

A key goal in taking over the two agencies is to inject some confidence into the foreign debt markets, to keep the flow going, particularly China.

The Fed's urgency to achieve the takeover may have been fueled last Friday when the Mortgage Brokers Association shut down Silver State Bank in Nevada, the 11th federally insured bank to fail this year. The troubled housing market has sent ripples through the entire economy, including an uptick of the unemployment rate to 6.1 percent, a five-year high.

Critics of the action claim that, contrary to the intentions when the sibling companies were created, taxpayer money will be used to achieve the takeover. The Fed's effort to stabilize Freddie Mac and Fannie Mae will include buying up to $100 billion in the preferred stock of each company over the next few years. Investors worry that the takeover will cause the value of their stocks to tank.

CEO of Fannie Mae, Daniel Mudd, and CEO Richard Syron of Freddie Mac will likely be replaced, though initially they are being kept on as advisors in the transition.

* Alt-A loans are alternative documentation loans, which allow borrowers with good credit to obtain loans without verifying income or documenting assets held. The loan approval is based largely on the applicant's credit score.

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