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Fannie Mae and Freddie Mac in Trouble: What Does a Govt. Bailout Mean for You?

Two of the nation's largest buyers of mortgages, referred to as Fannie Mae and Freddie Mac, have seen hard times in recent months.

Losses in April and May have prompted investors to start dropping the stocks like hotcakes, and just last week the share value for each plummeted.

After these damaging signs, the Federal Reserve board and its chairman Ben Bernanke were forced to step in to ease investor concerns by unfolding a plan to back the two companies.

Specifically, Bernanke pledged to ask Congress to extend more credit temporarily to the two companies as well as create an option for the government to buy stock.

Stocks rallied a bit upon announcement of Bernanke's pledge, but the general concern over the wellbeing of Fannie Mae and Freddie Mac remains.

Who is Fannie and Freddie?

Together, the two companies back around $5 trillion in mortgages, almost half of the entire US housing industry.

A collapse of either company would be devastating to the economy, and could send these effects across the world.

Of course, you may have heard about Fannie Mae and Freddie Mac before in the "Money" sections of your newspaper, or heard about them in conversation recently.

You may even have a mortgage loan backed by one of these two mortgage giants. But you may be wondering how this scenario affects you.

The Federal National Mortgage Association-nicknamed "Fannie Mae"-was created as part of Roosevelt's New Deal to encourage homeownership by buying mortgages from banks to free up more of their money to be offered in home loans.

They used what's called the "secondary mortgage market"-that is, they buy bonds or securities backed by the value of mortgage loans, pool them together, and then sell them to investors. From 1938 to 1968, Fannie Mae held a virtual monopoly on the secondary mortgage market.

When Fannie Mae was made into a private corporation in 1968, the government wanted to provide competition in the mortgage market, and so founded the Federal Home Loan Mortgage Corporation, or Freddie Mac, in 1970.

Since that time, the two companies have continued their dual dominance of the secondary mortgage market, and currently hold virtually all of the mortgage-backed securities in the US housing market.

Market Dominance Can Be Dangerous

And this overwhelming domination of the market is the very thing that has placed Fannie Mae and Freddie Mac in jeopardy.

So many of the mortgage loans purchased over the past five years have defaulted or gone into foreclosure, and many that have not defaulted have declined in value, some significantly.

When you begin to pool these worthless mortgages together, you end up with a lot of mortgages that are collectively worth vastly less than the securities they back.

This pooling technique on the secondary market allowed banks to slip through many subprime mortgages to Fannie Mae and Freddie Mac, and the two institutions willingly took them, knowing that, when pooled together, the defaulted mortgages would not affect the overall total in significant terms.

However, the enormous volume of mortgages that have gone into default, coupled with dropping home prices, has ballooned these previously insignificant losses into major ones.

What It Could Mean for You

The ramifications of this history are many. If Fannie Mae and Freddie Mac fail and can't back loans anymore, interest rates will go up.

Banks won't be originating as many loans because they don't have the guarantees they once did.

This means the number of homebuyers will drastically shrink, both because banks won't be authorizing as many mortgage loans and because the ones they do authorize will be out of reach for many homebuyers (higher down payments, higher interest rates, smaller loan amounts).

If the government completes a bailout, as looks more and more like the case, it would use taxpayer money to pay for buying stocks in the companies. It could cost up to $1 trillion in taxpayer money, which likely means higher taxes.

More importantly, it could damage the creditworthiness of the United States, making future loans to the government more difficult to obtain.

With the national deficit at nearly $10 trillion, the only thing going for the US is its credit rating. And when that goes....

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