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.

Q: Do the companies have sufficient reserves to withstand the current downturn?

A: They've consistently said they do. As of June 30, they reported a total of $84 billion in reserves. Critics — and now presumably the Treasury Department — have reason to doubt. Together, the companies own or guarantee more than $5 trillion, a staggering sum when measured against their reported capital.

Q: How does the intervention compare with that of the Federal Reserve last March when it brokered the sale of Bear Stearns to JPMorgan Chase?

A: Both steps were taken mainly to settle jittery markets. Both are huge and unprecedented intrusions by government into publicly-held corporations. One key difference: Bear Stearns was at imminent risk of failure. Fannie Mae and Freddie Mac are not.

Q: Past managements of Fannie Mae and Freddie Mac were investigated for manipulating accounting and earnings, which led to billions of dollars in earnings restatements. Is the current problem related?

A: No connection is apparent.

Q: How does the intervention affect mortgage borrowers and company shareholders?

A: With explicit government backing now, bond investors may demand less of a default premium. In turn, that could bring down mortgage rates in relation to benchmark Treasury securities.

Q: How does it affect me as a taxpayer?

A: The Treasury Department expects that periodic infusion of capital is cheaper than a big bailout in a future crisis. And the government is taking a new type of preferred stock in return for public money. But only time will tell the cost to taxpayers.

By Thomas A. Fogarty, USA TODAY