Fannie and Freddie

All sorts of people have been calling my cellphone this weekend, asking for an explanation of what’s “really happening” with the Freddie Mac, Fannie Mae bailout.

Really briefly, here’s what’s going on and what I think it means.

Freddie Mae and Fannie Mac are essentially mortgage financers. Banks sell mortgages, package them all together, and then sell them as debt to other investors – usually other banks, investment firms, mutual funds or pension funds. These are the famous “mortgage backed securities” everyone is talking about.

Freddie and Fannie buy lots of these mortgages and then resell them at a profit. The rate they receive from the debtors (the mortgage money they collect) is at a better rate of interest than what they pay out to the institutions buying their packages of mortgages. The weird part is that Freddie and Fannie aren’t just regular companies. The mortgages they resell are ultimately backed by government guarantee. That’s right: they are private companies, owned by shareholders, but the mortgage securities they sell are backed by the US Treasury.

This means that the value Freddie and Fannie really provide is to guarantee loans. Because of their government backing, they have the ability to clean up or add cred to everything they touch. Think of it like money laundering: all you have to do is pass some low quality mortgages through one of these companies – even for just a couple of hours – and they’re as good as new. It’s like touching the recharger in a video game – you get all your strength back.

Problem is, too many of Freddie and Fannie’s loans were no good. And the cash cushion they told everyone they had turned out to be a lot smaller than they were leading the world to believe. (Whether they intentionally overstated their cash cushion or just added the columns wrong has left to be seen.) But the long and short of it is that the company is in such bad shape that the government is stepping in and taking over the whole company.

Why? A few reasons. First off, Freddie and Fannie had to get their money from somewhere, right? How else could they buy all those mortgages? Well, they got a lot of that money by selling bonds – a lot of them to foreign investors. Now, they don’t really have the money to pay those bonds back. And that means they have even less money to buy all those mortgages from banks. Without a place to sell their mortgages – and “clean” them – banks can’t lend money to prospective home buyers. And without a good supply of mortgages, the housing crisis gets even worse.

So the Feds are coming in and taking over the two companies, kicking out management, and buying the mortgages themselves. They’re also going to back all the mortgage-backed investments that Freddie and Fannie have been selling. They’re even going to pay back all those bondholders, foreign and otherwise, who put up the money for the mortgage purchasing.

The only ones they’re not going to pay back are the shareholders. All the people who own Freddie and Fannie stock, like people with these once-safe stocks in their 401k plans and mutual funds, will be left with investments worth nothing.

The other people left holding the bag, as usual, will be the taxpayers. The billions of dollars these companies were about to lose on their bad mortgages will now be paid with our tax money. While it might be a necessary bail out of the housing market, this doesn’t stop anyone from foreclosing on their homes. All it means is that when we do foreclose, the investment firm that bought our Freddie-cleansed loan will still get paid.

In the bigger picture, I have to wonder what this will do to the stock market. This bailout pays back bondholders and “preferred” shareholders, but leaves regular old “retail” public shareholders losing all their money. If people begin to put two and two together, they will come to realize that owning publicly sold shares puts them at the very bottom of the totem pole as far as getting anything out of a dying company. Being “bailed out” may save those who hold bonds, but does nothing for those holding shares, who will likely be left with little or nothing.

Given that many corporate bonds are now selling “below par,” or below their original price, this presents an interesting set of scenarios. Will people start dumping overpriced stocks in favor of now discounted bonds, especially since discounted bonds pay very high interest rates and – and least in this case – don’t present the same risks as stocks? Will this week see investors encouraged by a government bail out and rushing into stocks or will stock investors instead see it as a sign that they will be last in line when the going gets rough?

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