With Fannie and Freddie, the US Is Bailout Nation

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Illustration by C.J. Burton for TIME

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In what is getting to be something of a habit, Treasury Secretary Hank Paulson ruined his own and a lot of other people's weekend by choosing the morning of Sunday, Sept. 7, to announce the seizure of money-losing mortgage giants Fannie Mae and Freddie Mac.

Fannie and Freddie are--childish names and all--by far the biggest financial institutions ever taken over by the U.S. government. Their bailout amounts to a stunning return to government control over the U.S. financial system, incongruously led by a former Wall Street boss (Paulson) working in what is purportedly a conservative Republican Administration.

It's also yet another episode in a now year-old financial crisis that shows no signs of abating. Paulson's announcement briefly rallied stock markets around the world. But jittery investors kept running for the exits at Seattle-based thrift Washington Mutual and the investment bank Lehman Bros.--although Lehman's earnings announcement on Sept. 10 sent the stock up slightly, despite the revelation of a $3.9 billion quarterly loss.

Americans not versed in financial-market arcana can be forgiven for scratching their heads at all this and wondering what the heck is happening and what it means for them. Here are a few answers.

1 | What are Fannie and Freddie again? Fannie Mae and Freddie MAC--let's call them Frannie for short--are mortgage lenders. They don't make loans directly but buy them from banks, thrifts and mortgage companies that do. They hold on to some loans but repackage most of them as mortgage-backed securities (MBSS) and sell them to investors, thus sustaining the flow of money into the real estate market.

Fannie Mae began life in 1938 as the Federal National Mortgage Association, a New Deal government agency, and was privatized in 1968 to get its debts off the government's books. Two years later, Congress created Freddie Mac, the Federal Home Loan Mortgage Corp., in part to give Fannie some competition. The firms became odd hybrids--government-sponsored enterprises (GSES) accountable to private shareholders. And they got away with holding only tiny capital reserves to insure against losses in their giant portfolios--partly because of their quasi-governmental status and partly because mortgages were supposed to be safe.

But the worst housing slump since the Great Depression--prices are down 18% since mid-2006, according to the S&P/Case-Shiller national index--has made once safe mortgages look perilous and Frannie's capital cushion look alarmingly skimpy. In July, in another of his Sunday bombshells, Paulson asked Congress for the authority to do (and spend) whatever it took to keep the companies from going under. He soon got what he wanted, and he said he hoped that alone would be enough to see them through. But after taking a closer look at the exact state of their capital reserves and watching buyers begin to shy from their debt, he stepped in.

Treasury agreed to backstop the companies to the tune of $100 billion each, in exchange for an ownership stake that will be determined by just how much money taxpayers have to pony up. The companies are to be operated as going concerns by the Federal Housing Finance Agency (FHFA), their regulator. The FHFA has already told the CEOs to go (albeit with lush severance packages), but most other executives are being asked to stay. The companies' shares continue to trade, although their market value dropped more than 80% the day after the takeover was announced.

2 | How will this bailout affect my mortgage? It shouldn't affect existing loans at all. But Treasury's guarantee of Frannie's debts has already brought down rates on new mortgages because worries about the companies' future had been driving up rates. Two days after the takeover, the average rate on a 30-year fixed mortgage was down to 5.79%, from an average of 6.55% the week before, according to Bankrate.com As part of the takeover, Treasury announced that it will begin buying mortgage-backed securities--starting with about $5 billion in purchases in the next month. By making more money available for mortgages, this should push rates down even more.

Lower mortgage rates make houses more affordable, providing support to the reeling housing market. But there's still a giant supply of unsold houses, and prices are still high relative to rents and incomes. So don't expect a big housing rally.

The better way to view the Frannie takeover is as an attempt to prevent the housing bust from getting dramatically worse and to stave off financial collapse. The companies' combined share of new mortgages rose as high as 80% earlier this year as other lenders retrenched. The percentage has dropped somewhat since, says FHFA Director James Lockhart, but if either Fannie or Freddie had to stop buying mortgages, rates would clearly skyrocket. If either firm actually defaulted on its debts or MBS guarantees, the consequences might be catastrophic. Why's that? Read on.

3 | Who gained the most from this deal? The big beneficiaries were the owners of the $5.3 trillion in Fannie and Freddie bonds and MBSS. Therein lies a fascinating, and disturbing, story. For years, the governments of countries that have run big trade surpluses with the U.S.--mainly Japan, China and the oil exporters--put their excess dollars into Treasury securities. When budget surpluses from 1998 to 2001 began to shrink the supply of Treasuries, foreign governments looked to Fannie and Freddie debt as an alternative. When the U.S. returned to deficits in 2002, they kept buying Frannie debt because it paid higher rates than Treasuries did.

Treasuries are explicitly backed by the full faith and credit of the government. Fannie's and Freddie's paper, on the other hand, have long included the disclaimer that they are "not guaranteed by the United States." But both firms were creations of Congress and had access to a Treasury line of credit. As a result, Paulson said when he announced the takeover, "central banks and investors throughout the United States and around the world ... believe them to be virtually risk-free." And because the U.S. government created this perception, Paulson felt he had little choice but to make perception a reality.