Q&A: How and why did Fannie and Freddie get into trouble?
— -- Some questions and answers about Fannie Mae and Freddie Mac:
Q: What do Fannie Mae and Freddie Mac do?
A: They provide liquidity for home financing in two ways: They buy mortgages from banks and other loan originators for their own corporate portfolios. They also package originators' mortgages for re-sale to investors. The companies guarantee payment of principal and interest to investors in their mortgage-backed securities.
Q: So what's the problem?
A: Several things. Since the housing market began its steep decline two years ago, Freddie Mac and Fannie Mae have faced sharp increases in delinquencies and foreclosures. Until the housing decline, investors in their mortgage backed-securities had nearly complete faith that the companies could repay them or that the government would step in if the companies faltered. The longer the housing market struggles and the more company losses mount, the more that investors worry about repayment.
Making things scarier is the withdrawal from the business of issuing mortgage-backed securities by the big investment banks that used to compete with Fannie Mae and Freddie Mac. The two companies have been involved in more than 70% of all new mortgages recently, adding to their potential liabilities as the housing slump continues.
Q: Why didn't Fannie Mae and Freddie Mac get out of the business when housing turned bad?
A: They can't. They have charters issued by the federal government that require them to be in the business of buying and packaging mortgages.
Q: So even before the takeover, the companies had a tie to the federal government?
A: Yes. And they've benefited greatly from it. Although the government offered no explicit guarantee that it would stand behind Freddie Mac and Fannie Mae securities, the bond market always assumed it would. Because of that perceived safety, bond investors were willing to take a little less of a return. In turn, home buyers benefited from slightly lower interest rates.
In explaining government intervention Sunday, Treasury Secretary Henry Paulson said the ambiguity of the companies' link to government can no longer be tolerated. "Government support either needs to be explicit, or it needs to be non-existent," he said.
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