Fannie Mae and Freddie Mac – Where There is Smoke, There is Fire

The rumor mill has been circulating about the potential collapse of the two mortgage giants Freddie Mac and Fannie Mae. This has been the reason for a lot of the loss in the stock market over the past week. Let’s take a look at what all of this means

Freddie Mac and Fannie Mae are Government-sponsored entities that were originally created as a means to help low income homeowners experience the American Dream of Home Ownership.

In the 1930’s, Congress created the Federal National Mortgage Corporation, or Fannie Mae, to encourage banks to make loans to low-income Americans by agreeing to purchase those mortgages from banks. If Fannie Mae, who was created by the Government, could step in and take the risk away from the banks by insuring the loans against loss, then the dream of home ownership would become more of a reality.

In 1970, Congress created a second agency called the Federal Home Loan Mortgage Corporation, or Freddie Mac. By the late 1980’s, these two companies were responsible for around 30% of the loans that were being written.

The two entities would buy or federally insure the loans from the banks. Then they would either own the mortgages themselves or they would take the loans and package them up into a bond and let Wall Street sell them to clients as income-producing investments.

Well what started out as a way to help low income Americans expanded to insuring loans up to $417,000. Of course, this “Government-backed” mortgage machine got completely out of control along with everyone else during the last 5 years and now has big problems.

According to a Wall Street Journal article from last Friday, together these two companies insure or own over 5.8 trillion dollars worth of loans. They are involved in roughly 70% of all mortgages written today. The mortgage markets desperately need these two companies to stay functional. If either were to fail, the implications would be disastrous for the economy.

The problem for these two companies is the same problem that Bear Stearns encountered. They are trying to raise money just to exist and no one wants to give them any. The investors who are willing to give them money will only do so at very high interest rates.

If these two companies are involved in some way with 70% of the mortgages, then anything that would prevent them from being that involved would mean big problems for the markets, the real estate industry, and the economy.

So the Federal Government steps in and announces on Sunday that they will in a sense bail out the two mortgage giants. They are expanding the line of credit or amount of money that the two mortgage giants can borrow. A short-term fix for sure. The Government is depending on one thing to occur – the real estate and mortgage markets to improve. Unfortunately, that could still be way off into the future. Will this bail-out attempt prove to be an exercise of throwing good money after bad or a real solution?

The bigger problem is that the Federal Government continues to interfere with markets that are intended to be free. They have been doing this behind the scenes for years. However, in recent months, they are doing it in a big way right out in the open.

Not only are they making money available to the two mortgage giants, but Paulson also wants to be granted authority to buy stock in both of the companies if needed. I can understand opening up the line of credit. However, the Government intervening to buy stock? That is getting a little out of control.

What are the ramifications for this move by the Government? I would suggest that it only pushes the problem further out into the future. When it is all said and done, these problems that we face in our credit markets have to be corrected and the only way for the problems to be truly corrected is to allow nature to take its course, losses in the market to be realized and not postponed, and most importantly, for the Federal Government to stay out of the way.

What this does for the stock market is creates large amounts of uncertainty. I am sure that much to the surprise of Treasury Secretary Paulson who created the bail-out plan, the markets didn’t care today as the stock market had another losing day. It is a message being sent to the Government that there is an extreme lack of confidence in the Federal Government.

Copyright © 2008 Prudent Money and Bob Brooks. All rights reserved.