Fannie and Freddie: The Intervention

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Fannie and Freddie: The Intervention

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The mortgage crisis may have claimed its largest victims with the reports of fed intervention in mortgage giants Federal National Mortgage Association (FNMA or Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). From NPR:

The federal takeover of Fannie Mae and Freddie Mac is aimed at preventing a "serious risk to the financial system," which is "critical to our overall economy," Treasury Secretary Henry Paulson tells NPR.

The Bush administration on Sunday said it was taking over Fannie Mae and Freddie Mac, the troubled mortgage companies that play a key role in the U.S. housing industry. To keep the companies afloat, the administration said it would funnel billions of dollars in taxpayer money into the companies.

This specific move is not about bailing out property owners struggling or in default on their mortgages. It's about preserving the financial infrastructure that makes new mortgages possible. In a nutshell, when your local bank loans a buyer the money for a house, it decreases their ability to loan the next prospective borrower the money to buy his or her house, or car, or whatever. Fannie and Freddie were created in part to buy those mortgages from banks thus freeing up new money for new home loans. It's the lubricant allowing the wheels of the mortgage and real estate industries to turn over and it also helps more people own a home.

Fannie & Freddie then either hold those loans themselves and collect interest and principal, or package the mortgages into groups called "tranches" and sell them to institutional and retail investors. The tranches are a type of bond, usually with generic names like Collateralized Mortgage Obligations (CMO) or Collateralized Debt Obligation (CDO). Some of those mortgage obligations are government backed, meaning if the borrower[s] making up the underlying bond defaults, the government will step in and make timely payments of interest and principal to the investors holding them. Not all of the obligations are backed by the government, and therein lays the rub, or at least one part of it.

The mortgage bubble expanded in part because of 'subprime' mortgages -- lenders put together mortgages to borrowers who, based on income, credit history, and collateral, wouldn't have qualified in the past. Some of those mortgages had an adjustable rate, allowing the borrower lower interest payments on a larger principal and thus able to afford a bigger or nicer house than s/he would have had with a fixed rate, plus they were often used for investment properties. Now, as interest rates have risen -- a relatively small rise in rates can mean big increases in the monthly mortgage payment -- and property values have fallen, those borrowers can no longer charge enough rent to pay the increasing monthly mortgage. Since in many cases the borrower doesn't live on the investment property, they don't have the same incentive to bend heaven and earth to make those payments. They're tempted to just walk away, mail the keys to the mortgage company, and many of them have done just that. The result is falling property values, which affect everyone sooner or later including lenders, borrowers, and local tax revenues, and the whole shebang can feed back on itself until it's a full blown economic crisis.

That puts traders and investors in a hell of bind: they have no idea what some these tranches are worth, especially the ones made up of subprime mortgages. If the mortgage can't be priced, then neither can the CMO or CDO it makes up, which means they can't sell it to investors -- or investors are wary of buying it -- and thus money cannot be freed up for new loans undercutting one of the main reason Fannie and Freddie were created in the first place. In the meantime the income and paper value of those mortgages plummet and the company holding them swirls around the drain.

That's a real bare bones outline of one of the reasons Freddie and Fannie are deemed so vital to the economy and why the federal government might be compelled to intervene and lubricate those markets with liquidity. That's where some of those billions in tax payer dollars quoted in the NPR article above are going. How exactly the intervention is going to address the pricing question, who gets hurt and who gets helped, and what good it may do in the end remains to be seen. The bailouts are the responsibility of the Treasury Department, the Federal Reserve and the Federal Housing Finance Agency. But ultimately the borrowed buck stops on the desk of the chief executive, yeap, that would be George W. Bush.

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