Questions About Fannie and Freddie

Here's everything you need to know about the future of the mortgage giants and their role in the real estate industry

by David Bogoslaw

It's astonishing how quickly conditions in the financial markets can go from bad to worse. Just look at how a spiraling crisis of confidence at Bear Stearns sank the brokerage house in the blink of an eye. Now, it's mortgage backers Fannie Mae (FNM) and Freddie Mac (FRE) that stand at the precipice, after a week in which their share prices fell 45% and 47%, respectively.

U.S. Treasury Secretary Henry Paulson did his best to tamp down Wall Street chatter that a government takeover of the two companies was imminent. Before noon ET on July 11, he released a statement saying there was no plan for a bailout and that the primary focus is to support them in their current form. James Lockhart, director of Fannie and Freddie's regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO, said more than once this past week that the companies have ample capital on their balance sheets. Meanwhile, the Federal Reserve Board declined to confirm reports that Chairman Ben Bernanke had reached out to Freddie Chief Executive Richard Syron to assure him that the agencies would be given access to the central bank's discount window.

Any questions of solvency for Fannie and Freddie revolve around whether foreclosures spike further and the two companies' credit losses surge. Insolvency could cause the U.S. mortgage market to grind to a halt; Fannie and Freddie currently guarantee about 81% of al U.S. mortgages. That possibility certainly weighed on the minds of investors on July 11, as Fannie shares finished down 22.4%, at 10.25, while Freddie bounced back from being down as much as 51% to close 3.1% lower, at 7.75.

Here are some key questions about the fates of Fannie and Freddie and how they would affect home buyers and others.

What are the odds the government will take over Fannie or Freddie?

There is probably no actual takeover plan, says Howard Glaser, a mortgage industry consultant in Washington: "That story was way overblown. Their goal is to keep Fannie and Freddie strong but to keep them private." The cause of all the turmoil this week were news reports speculating about a bailout, not any change in the financial conditions of Fannie or Freddie, Glaser says.

Robert Napoli, an analyst at Piper Jaffray (PJC) in Chicago, agrees that a takeover isn't in the cards. "A much more likely scenario is that the government would put money into Fannie and Freddie, as opposed to a conservatorship," says Napoli, who has a neutral rating on both stocks. (Piper Jaffray received compensation for noninvestment banking services from Freddie in the past year and makes a market in the securities of both Fannie and Freddie.) "The government doesn't want to own Fannie and Freddie. They know they can't own them long term. They want to make sure they have enough capital to get through this cycle. The last thing they want is for some drastic change in the organization of Fannie and Freddie at a time when they're having trouble."

The only legal mechanism for taking control is putting the companies into conservatorship, with a regulator assuming authority for their operations. Once it took control, the government might decide to create a resolution trust that would buy all the bad mortgages, as it did when it bailed out the savings and loan industry nearly two decades ago, says Michael Wallace, global market strategist at Action Economics in San Francisco. Whether it creates such a trust would depend on how much confidence the government has in the agencies, he says.

A less draconian option would be for the Treasury or the Fed to inject a big wad of capital—say, $10 billion—into each of the government-supported entities, or GSEs, as Fannie and Freddie are known.