Tuesday July 22, 5:36 pm ET
By Dave Carpenter, AP Business Writer What happens when Fannie flags? A primer on 2 mortgage giants as government offers lifeline

CHICAGO (AP) -- Behind their down-home names, Fannie Mae and Freddie Mac are so vital to the economy that the government scrambled to offer them a lifeline. But what exactly are they, and what do they do?
They are the engines behind a complex process of buying, bundling, slicing and selling mortgages that remains a mystery even to millions of Americans whose home debt passes through their hands.
They were set up by the federal government -- Fannie in 1938, Freddie in 1970 -- to help more Americans buy and keep their homes. Today both are public companies, their stock traded on the open market.
But Fannie and Freddie don't deal directly with homeowners. Instead, they buy mortgages away from the banks that already hold them, providing cash that allows banks to make more home loans and take on more debt.
Then Fannie and Freddie bundle the loans together and sell pieces of the whole to investors as what are called mortgage-backed securities. They pay a guaranteed rate of return -- like Treasury bonds, but more lucrative for investors.
While they have not carried the explicit backing of the federal government for decades (Fannie became private in 1968, while Freddie was set up that way), each has a $2.25 billion line of credit with the government.
And the implicit presence of Uncle Sam helped the pair grow fast.
As more and more Americans sought to buy homes, Fannie and Freddie's portfolios grew more than 10 times from 1991 to 2003. Today they hold or guarantee about $5 trillion in mortgage debt, nearly half of what's outstanding in the United States.
The two were immensely profitable even as the explosive growth in home values slowed, then home prices began to fall. Borrowers were stuck with payments they couldn't afford. Thus began a wave of foreclosures.
Fannie and Freddie were mostly unaffected by the subprime lending crisis that has grabbed so many headlines. But even foreclosures on more desirable mortgages took their toll.
Stock in each company has plummeted more than 80 percent in the past year as investors worried about the fallout. And the actual holdings of Fannie and Freddie dwindled.
Compounding the danger, the two companies, helped by high-powered lobbying, are allowed by the government to keep much smaller cushions of capital to fall back on than other companies.
Banks are required to hold a reserve of cash and other investments equal to about 10 percent of the dollar amount of loans they make. The cushion is intended to keep them solvent in case some of the loans go bad.
But because of special regulatory rules passed by Congress, Fannie and Freddie were able to grow their combined liabilities to more than $5 trillion that are now backed by only $81 billion in capital.
Seems like a lot of money until you realize that Fannie and Freddie have lost a combined $11 billion in just the past year -- and that analysts are forecasting billions more in losses in the quarters to come.
"When house prices fall very dramatically ... Fannie and Freddie have very little capital to protect themselves from those losses," said Deborah Lucas, a professor of finance at Northwestern University's Kellogg School of Management.
Enter the federal government and its rescue package -- additional, unlimited lines of credit, plus the option for the federal government to invest directly in the two companies.
The top budget analyst for Congress said Tuesday the rescue package could cost taxpayers as much as $25 billion.
But the analyst told lawmakers in a letter that the odds were better than even that the government would not have to step in to prop up Fannie and Freddie by lending them money or buying stock.
Congress is expected to vote this week on a housing measure that would include the offer of a lifeline for Fannie and Freddie. Treasury Secretary Henry M. Paulson said keeping the pair in business is "central to the speed with which we emerge from this housing correction." He really had little choice in offering the lifeline: A collapse of Fannie and Freddie and big write-downs in the value of the debt they sold could cripple the U.S. banking system because almost all banks have some Fannie and Freddie securities as part of their core holdings.


Read More Here:
http://biz.yahoo.com/ap/080722/fannie_and_freddie.html


Fannie Mae: http://www.fanniemae.com
Freddie Mac: http://www.freddiemac.com

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