For average investors and consumers, figuring out what the government seizure of Fannie Mae and Freddie Mac means can be tough.
The truth is that most of us possess only a vague understanding of what both companies do and why they are important to the U.S. economy. As a result, we're not sure whether to panic or celebrate Sunday's announcement that the federal government has taken control of two dominant forces in the nation's mortgage market.
Are the government seizures a sure sign of an economic apocalypse? Or will they reignite the sagging real estate market?
The most likely answer: neither. The final impact will lie somewhere in between, but still there are lessons to be learned, dangers to be avoided and benefits to come.
Among the lessons, the most important -- once again -- is the importance of diversification when building an investment portfolio, particularly when company stock is available at attractive terms.
In less than a year, shares of both Fannie and Freddie both had lost more than 97 percent of their value as of midday Monday. That's a stunning fall for two stocks considered smart, reliable investments in the nation's housing market.
The pain has been particularly acute for Fannie Mae and Freddie Mac employees who loaded up on company shares when times were good. Fannie Mae offered an employee stock ownership plan that at the end of 2006 was worth $116 million, according to The New York Times. Today, that amount is worth less than $2 million.
At Freddie Mac, an employee stock purchase plan allowed workers to buy company stock at a 15 percent discount. The plan held $24 million in stock at the end of last year, according to the Times, and by Monday the value of that stock fell to $700,000.
Compare those 97 percent plus losses to the minor impact on mutual fund investors who owned slivers of Fannie Mae and Freddie Mac.
According to Morningstar, the mutual fund owning the largest number of shares in Fannie Mae at the end of June was the Dodge & Cox Stock fund. It owned more than 32 million shares at the time, but that accounted for just 1.5 percent of the fund's overall holdings, meaning even if Fannie Mae shares eventually become worthless, Dodge & Cox Stock investors can withstand the hit.
Remember, diversification reduces risk.
Turning to dangers to be avoided, I would suggest individual investors resist the urge to take drastic action as a result of the Freddie and Fannie takeovers.
I'm sure there are some individuals who see the government's action as a sign the U.S. financial system is in collapse. I hear it from clients and I hear it from family members. They think that we're one step away from a 1929-like market collapse and that they need to dump all their stocks and bonds in favor of CDs and other cash holdings.
I say, it may be a time to be cautious -- particularly if you're less than 10 years away from retirement -- but smart investing is not an all-or-nothing activity. Rather, it's about finding the right balance for you. It might be a smart time to boost your allocations or short-term bonds by 5, 10 or even 15 percentage points, but avoid the temptation to cash in everything.