FORECLOSURES !

Freddie Mac and Fannie Mae. Why should we be worried?

I saw on the news that Freddie Mac and Fannie Mae hold 50% of all mortgages in the USA and are backing 70% of all new mortgages.

And they are starting to feel the foreclosure crunch.

They are privately held companies that are GSE’s (gov’t sponsored entities….started by the fed but now in private sector. They have stockholders.)

Questions:
What happens to the mortgages if they fail? (I realize that it is likely that the gov’t would bail them out ….but what would happen if they didn’t?)

As it is privately held, w/ stockholders, why should the gov’t (and taxpayers!) bail them out?

Why is this causing such waves thru the international financial markets? In short, what is the big deal?

The short answer: yeah, there’s reason to be worried. Not panicky, but worried.

Fannie Mae (FNMA) and Freddie Mac (FHLMC) are “secondary mortgage” companies. Essentially, they act like insurance companies for the big mortgage-lending banks. They provide guarantees against mortgage failure. It’s a lot like having them take on the mortgage itself, though they leave the mortgage itself in the hands of the banks to manage the actual payments. (That’s why you don’t write checks to Fannie Mae.)

They then issue bonds. They pay interest on the bonds to bond-holders from the money that they get from the banks for the guarantees. Those bonds are backed by large chunks of mortgages all bound up together (“tranches”).

It’s all about moving around risk, just like everything else in the financial market. Ultimately, it’s a way for you as an individual investor to help somebody else out with a mortgage. You take on the risk, and share the reward.

That’s the rub here: that risk ultimately gets moved to you. Take a look at the biggest holders of FNMA and FHLMC stock. They’re companies like Vanguard and Legg Mason, who buy it using money from your mutual fund and pension funds. The risk has moved from the mortgage company to FNMA/FHMLC to the institutional investor to you.

That’s why it’s such a big deal. If these companies go under, you lose money. Potentially lots of it.

With such a complicated chain, it’s hard to know exactly who loses the money. And those people at risk of losing money are the ones were the ones who benefited when the mortgage market was bubbling. Everybody saw the reward but not the risk. Now the risk is coming up, and nobody’s happy.

As for the mortgages… well, they’re the problem in the first place. The mortgages that fail are the beginning of the chain, not the end of it. Ultimately, companies may write off the mortgage as unpayable, in which case the ultimate holders of the bonds that FHLMC/FNMA created lose some of the money they were expecting. The can foreclose on the house and sell it for what it’s “really” worth, and they pay bond-holders out of that, though less than they hoped.

The mortgages that don’t fail continue to pay dividends all along the line. These tranches of mortgages aren’t complete losses. You’re not losing all your money, just some of it.

The next problem is that the losses bubble out. Mortgages were supposed to be some of the safest investments in the world. They were loans with collateral, and there’s always a market for a house, right?

The entire financial market is based on moving risk around. And what’s “risk” worth? It’s all relative to what the minimum risk. After all, if you have a near-guarantee that somebody will pay off their mortgage, at 5% interest, you won’t buy into something riskier (like a company stock) for less than that. When mortgages fail, people have to sell their stock to make up for the losses, and people buy it only because they’ve realized that the 5% interest they were getting on the mortgages isn’t really as safe as they thought it was. The whole stock market falls because of it.

That means that some companies are considered “too big to fail”. It’s a bit like putting money into car repairs: you do it only when you think the car is going to run well-enough after the repair, and the consequences of letting the car fall apart are worse.

If FNMA/FHLMC fail, people will have a harder time getting mortgages, because the big banks won’t be able to manage the risk of taking them on. As we showed, that bubbles out to every other investment, making it hard to start companies, which are the engine of jobs in the economy. And if people lose their jobs, they don’t pay their mortgages…

That only happens to really, really BIG companies. Small companies can fail without upsetting the whole market.

What’s “big enough” to qualify? Hard to say. Everybody thinks their investments deserve it. Chrysler did, and they got it. Enron did, and they were allowed to fail, and we all survived.

Right now, all of that risk is sitting out there, and nobody knows how much it is. That’s the ultimate problem with FNMA/FHLMC. They allowed mortgage companies to make loans to people who had no business getting loans, and then they guaranteed those loans. They passed that risk on, and everybody assumed that these were mortgages just like any other. People bought risk they didn’t understand.

And still don’t. It will take years before anybody really knows how many of those mortgages, in the hands of their mutual funds, are going to fail. People feel like they have plenty of risk already, and are unwilling to put their money into something else until they know how much money they really have. That grinds the entire economy to a halt.

So… the US Government bails them out, in the hopes that three or four years from now the bad mortgages will have failed and we’ll be left with just good ones. Thus far, the bailouts have been lo

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