Treasury Secretary Henry Paulson on Sunday moved to take control of Fannie Mae and Freddie Mac, which operated like private companies but had enjoyed implicit government backing until their seizure. The move aimed to bolster the complex workings of mortgage finance. Here are some frequently asked questions and answers on what the plan does and how it affects American homeowners.
Q: How do Fannie and Freddie impact mortgage finance?
They buy mortgages from commercial banks and other home lenders, then package these pooled mortgages and sell them into a secondary mortgage market as bonds, called mortgage-backed securities. This process is called securitization, and it allows banks to pass on the loan and not keep it on its own books, freeing up its balance sheet for more lending.
Q: Are Fannie and Freddie going bust?
No. But investors who purchase mortgage-backed securities – banks, investment funds and even foreign central banks – were concerned that as more Americans fall behind on their home payments, especially those with good credit, that Fannie and Freddie may have insufficient capital to withstand losses.
Q: So they could run short of cash?
That would be unlikely but not impossible. And Paulson believed it better to get out in front of a problem than wait for it to occur. Already, big investors like Pacific Investment Management Co., or PIMCO, the world's biggest bond fund, were frowning on buying Fannies and Freddies unless the government took bolder action.
Q: How does this help homeowners?
It helps in a broader sense. Since Fannie Mae and Freddie Mac own or back more than half of U.S. mortgage debt, anything to stabilize them helps the broader financial markets.
In recent months, investors have demanded higher returns in exchange for buying Fannies and Freddies. That led to a widening spread, or gap, between these bonds and, say, a 10-year Treasury bond. Mortgage rates take their cues from long-term U.S. government bonds, so it has had the effect of driving up mortgage rates.
Since a Fannie or Freddie will now effectively be government-issued debt, the gap should narrow and rates fall. A drop of 1 percentage point in rates equals about 15 percent savings on the costs of a mortgage over its life.
Q: So will the housing slump end because of Paulson's plan?
It won't end just like that. Mortgage rates are just one part of the equation. But given the erosion in home prices, lenders are still very reluctant to lend and have sharply tightened credit. Low rates won't mean much if banks won't lend. And the other half of the secondary mortgage market that doesn't involve Fannie and Freddie is run by the private sector – termed private-label mortgage-backed securities. And this part of the market is frozen over like tundra.
Q: Then what's the significance of the Treasury action?
It assures that the functioning part of mortgage finance, while facing challenges, continues to operate smoothly. Paulson himself spelled out why it's important to average Americans that turmoil in financial markets not be allowed to spread.
“This turmoil would directly and negatively impact household wealth from family budgets, to home values to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance,” he said. “And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today.”