Meet Fannie And Freddie

What are Fannie Mae and Freddie Mac, and what's all the fuss about?

With the turmoil in American mortgage market over the weekend, just what are Fannie Mae (NYSE: FNA) and Freddie Mac (NYSE: FRE), and what's all the fuss about?

What are Fannie Mae and Freddie Mac?

Behind the cringe-worthy folksiness of their names lie two of the world's most important financial institutions.

These are government-sponsored entities (GSEs), a strange hybrid of share-holder company and government agency. While there is no explicit government guarantee, it seems to be understood that the state will come to their rescue if necessary -- more about that below.

Their purpose, in addition to making a profit for shareholders, is to promote home ownership. Because of their GSE status and tax concessions, they have access to very cheap money which they make available at a higher price to mortgage providers.

They also provide mortgage guarantees, which facilitate a secondary market in mortgages, enabling them to be parceled up and traded.

Fannie Mae, the Federal National Mortgage Association, was founded in 1938 as part of President Roosevelt's New Deal after the Great Depression. Its website proclaims: "We are in the American Dream business", with references to family and community. Motherhood and apple pie are not explicitly mentioned, but like the government guarantee they seem to be implied.

Freddie Mac, the Federal Home Loan Mortgage Corporation, was founded in 1970.

Together, they account for approximately $5 trillion of America's $12 trillion in mortgage lending.

What went wrong?

The proximate cause of the Friday's falls in share prices was the collapse of IndyMac, a mortgage bank in California. This was similar to the Northern Rock situation in UK -- doubts over the quality of the balance sheet leading to a run on the bank, except that in this case the government stepped in immediately and took it over.

These fears rippled through the sector, with shares in Fannie and Freddie falling nearly 50% during the day, although they subsequently recovered some of that loss.

However, this was just the latest phase in a long decline for both companies. Freddie was the first to peak, in November '06, and has fallen 89% to Friday's close. Fannie was still on a high as recently as September '07, but has since fallen about 85%. Both shares are reportedly at seventeen-year lows.

To some extent, the mortgage crisis is a result of Fannie and Freddie's facilitation of the mortgage trading business. While the ability to sell mortgages on in the secondary market does help lower the cost to home-owners, it can also reduce the quality of due diligence on the part of mortgage providers. If mortgages can be easily sold on, thanks to guarantee from Fannie Mae,  why bother properly assessing the risks? But the risks are still there, now on Fannie and Freddie's books, and that's the big concern.

Both companies deny that they have problems with cash-flow, or with the value of their loans.

What can be done?

On Sunday, the US Treasury Secretary announced that he will ask Congress to approve a plan to allow the state to buy shares in both companies, and to provide additional lines of credit. Although denying that they need help, the companies have welcomed the move.

This is effectively the gilt-edged state guarantee that was understood by many to exist. They are often considered too big and too important to be allowed to fail.

But is it that easy?

Just throwing money at them may not be the solution. Some regard both institutions as effectively insolvent. If they collapsed, the resulting turmoil would throw the US housing market into even greater turmoil, and the dollar would plummet as overseas investors would lose confidence.

But keeping them afloat by piling more debts onto the US taxpayer could have a similar effect, albeit more slowly. If a full rescue is eventually required, the sums involved are huge even by the standards of the American budget. As The Economist points out, not only are they too big to fail, they may also be too big to rescue.

Because of the size of the problem, however this plays out it will have repercussions around the world.

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