6 Things You Need to Know About Fannie and Freddie

Could Uncle Sam take over the mortgage finance giants?

A Freddie Mac sign sits in front of its headquarters in McLean, Virginia. Shares in Fannie Mae and Freddie Mac have dropped to their lowest levels in 17 years.

A Freddie Mac sign sits in front of its headquarters in McLean, Virginia. Shares in Fannie Mae and Freddie Mac have dropped to their lowest levels in 17 years.

By + More

It wasn't that long ago that America's most powerful financial executives were telling us that the ugly credit crisis was loosening its grip. "We're closer to the end than the beginning," Goldman Sachs CEO Lloyd Blankfein told investors in April, just days before Jamie Dimon, JPMorgan Chase's top executive, said the credit crisis was "maybe 75 percent to 80 percent" done. But those hopeful days of spring must seem like decades ago for the folks at Fannie Mae and Freddie Mac, the latest credit-mess castaways. Fannie and Freddie's stock prices have plummeted more than 50 percent since the end of April amid investor concern that they don't have adequate capital to ride out the national housing storm. Things have gotten so bad that the federal government may have to step in.

The blink-of-an-eye evaporation of Bear Stearns—a once proud, 85-year-old investment bank—shows just how quickly the nation's credit turmoil can bring a franchise to its knees. But because of Fannie and Freddie's unique relationship with the government, and their powerful role in the mortgage markets, the problems—and potential solutions—facing them are unique.

What are Fannie Mae and Freddie Mac?

Fannie Mae and Freddie Mac are congressionally chartered, stockholder-owned companies—known as government-sponsored enterprises (GSEs)—that purchase mortgages from banks. Some of these loans—which are primarily fixed-rate mortgages to borrowers with strong credit—are held in its portfolio, while others are bundled into securities and sold off to investors. The feds established Fannie and Freddie to promote stability in the mortgage market by ensuring that banks have the funding they need to make new home loans. Today, Fannie and Freddie own or guarantee more than $5 trillion of home loans—or about half of all U.S. mortgages. Why are they important?

Fannie and Freddie have always been a key source of liquidity for the mortgage market, but the ongoing credit market turmoil has amplified their significance. As American homeowners have defaulted on their loans in alarming numbers, investors have turned up their noses at many investments backed by mortgages. But since Fannie and Freddie buy up primarily fixed-rate home loans to borrowers with sound credit—and the companies are perceived as having the implicit backing of the Federal government—investors have continued buying their securities. That has enabled banks to continue to make new home loans even as housing prices fall nationwide. What problems are they facing?

Investors are worried that the continued decline in home prices has slashed the value of Fannie and Freddie's mortgage holdings and investments, requiring them to raise additional capital to cover the losses. But raising more capital could prove very difficult, as bond investors, concerned about the health of the companies, are forcing them to pay higher interest rates on their debt. Fannie and Freddie could try issuing new stock, but that would dilute the value of existing shares, and—given how sharply their stock price has fallen recently—it's unclear if they'd be able to find many buyers. "The problem is it's almost impossible for them to raise money as their stock price collapses," says Ed Yardeni of Yardeni Research. "Who wants to buy their stocks if they are going down?" How significant are their capital problems?

Despite the market's reaction, Fannie and Freddie's capital levels are more than adequate, says Howard Shapiro, an analyst at Fox-Pitt, Kelton. "They have significant capital in excess of the regulatory mandated amounts, over $26 billion for Fannie, and $24 billion for Freddie Mac," Shapiro says. "It's just highly unlikely on a fundamental basis that Fannie Mae or Freddie Mac would become insolvent." Earlier this week, the director of the Office of Federal Housing Enterprise Oversight—the agency that regulates Fannie and Freddie—also said the companies have enough capital. The key factor behind the markets reaction is panic, not fundamentals, Shapiro says. "But panic creates its own reality," he says. And it is this crisis of confidence in the market that poses the biggest threat to Fannie and Freddie.