WHY FREDDIE MAC AND FANNIE MAE REALLY MATTER

A NY Times article, "A Trickle That Turned Into a Torrent," lays out how big the problem could be.

Virtually every home mortgage lender, from giants like Citigroup to the smallest local banks, relies on Fannie Mae and Freddie Mac to grease the wheels of the mortgage market. Virtually every Wall Street bank does business with them. And investors around the world own $5.2 trillion of the debt securities backed by the companies.


Perhaps the biggest single risk facing Fannie Mae and Freddie Mac, and with them financial companies and taxpayers, is that investors might simply lose confidence in the companies, leaving them unable to pursue their core businesses — buying home loans from banks and repackaging them for sale to investors.

That buying and repackaging is the lifeblood of the American housing economy, because it provides the capital that banks and other financial institutions use to write new loans.

As long as investors are confident that Fannie Mae and Freddie Mac are relatively financially healthy, then companies, banks and other institutions will continue lending them billions of dollars each week.

But, as the companies’ stock prices decline, wary investors have begun charging higher premiums for those loans.

Fannie and Freddie could suspend buying some loans — which could bring much of the American housing economy to a standstill.

Another risk is that, as investors lose confidence in Fannie and Freddie, buyers will begin demanding discounts on the repackaged loans the companies sell. Those repackaged loans, known as mortgage backed securities, are guaranteed by Fannie and Freddie. As the companies’ stock prices fall and their financial health declines, investors may become worried that Fannie and Freddie cannot honor those guarantees.

Investors might therefore demand prices that are too low for Fannie, Freddie and banks to make any money on the deals. In which case, banks may simply stop creating new loans.

“If people lose faith in Fannie and Freddie, then the whole system freezes up, and nobody can buy a house, and the entire housing market can crash,” said Paul Miller of the Friedman, Billings, Ramsey Group in Arlington, Va.

Although banks are typically prohibited from concentrating their money in the stock or bonds of any one company, those regulations create an exemption for debt issued by Fannie Mae and Freddie Mac, which have long been considered the safest of investments.

As Fannie’s and Freddie’s stock prices decline and they are forced to issue new bonds at higher interest rates, their old bonds become worth less. And as Fannie’s and Freddie’s old bonds decline in value, the many small and regional banks holding the bonds will likely be forced to declare losses.

Moreover, because Fannie’s and Freddie’s older bonds are so widely held, as those bonds decline in value, many people will see their portfolios decline.

“The major banks are taking write-downs of 20 percent to 50 percent of their assets,” said Sean Egan, managing director of Egan-Jones Ratings, an independent credit ratings firm. Just a 10 percent write-down in the value of Fannie Mae’s assets would be “a loss of $150 billion that taxpayers would need to offset. So you’re talking about the cost of another Iraq war.”