August 26, 2008 - You may not follow the ongoing drama, the one about Freddie Mac (Federal Home Loan Mortgage Corp.) and Fannie Mae (Federal National Mortgage Association). You probably see the headlines about problems each has, maybe wonder what the fuss is about. Since you don't own the stock or the preferred or any of the debt, you don't really spend too much time on it. You've got your own stocks with problems, or you've just got enough problems without any stocks.

The chance that these two giants would be allowed to fail is almost zero. Everyone understands their value. The challenge is to figure out how to keep them going without transferring their liabilities to the federal government. That's because every mortgage made by Freddie or Fannie has a guarantee attached, one that gives the buyers of these mortgages the comfort that if the borrower doesn't pay the monthly mortgage, the agency that guarantees the mortgage will. There are trillions of dollars on the line here.

Fannie Mae is by far the larger of the 2 GSE's (Government Sponsored Enterprise). It is the largest purchaser and guarantor of home mortgages in the country. Its charter is to buy mortgages from lenders such as banks and savings and loans, package them, then resell them in the open market. That creates liquidity for lenders and lowers lenders' risk. With more money flowing into the mortgage market from large investors such as insurance companies, retirement funds, etc., middle-income individuals and families can obtain mortgages to purchase new or existing homes.

These agencies play an important role in the health of the economy. If they don't buy mortgages and guarantee them, many families can't afford homes. The housing market is one of the important cylinders in the engine that drives the U.S. economy. Without an active housing market, many jobs are lost from construction workers to bank lending officers to furniture makers. There's no question of the need for Fannie and Freddie.

Rather, the question is: how do they exist going forward? Currently each is privately owned by shareholders though there is an implied government assurance behind each. Both were created by Congress. Fannie holds over a trillion dollars of mortgages. It was created in 1938, rechartered in 1954, then privatized in 1968. Freddie currently has $1.5 trillion in its loan portfolio. It was chartered in 1970. There's a minimum of $2.5 trillion in loans guaranteed by these 2 companies.

If they were to disappear and turn into government agencies, then the federal government would have to back those guarantees. With the added obligations, the ratings for U.S. debt would go down, raising the cost of any future borrowing by the government. That would push up interest rates everywhere along the debt hierarchy, making it more expensive for companies and individuals to borrow money, even pushing some from being able to borrow at all. Of course, the interest rate on a mortgage would go higher as well. The ripples are deep and wide.

The answer isn't to have the government take over these 2 behemoths, wiping out current shareholders and most likely the preferred holders as well. The answer lies in a compromise, one that allows both to continue operating until there is a "normal" real estate market. Most likely that takes the form of debt or at least the ability to borrow from the Treasury without resrictions, posting mortgages as collateral for the money.

These are loans, not equity, that must be repaid from profits by Fannie and Freddie, much like the Chrysler loans that saved the company years ago. There would be some risk to taxpayers but not as much as if the government bought an equity position since there would be mortgages pledged against the borrowings. And another stipulation: new government oversight and new management are a must.

Fannie and Freddie are more than mortgage facilitators. They're part of a vibrant economy that is stalled. To allow them to fail has significant negative implications, far more than just the housing market. Some experts believe the companies don't need real attention until early next year since they have more than adequate capital at the moment. But if losses are greater than expected, that capital will disappear quickly. An announcement from Treasury stating the borrowing window is open and will stay open would go a long way to help the stock, the preferreds and the outstanding debt holders. And it would make borrowing costs go down for both agencies which in turn would lower the cost of mortgage money which in turn would spur more home buying.

Taxpayers should be worried about the government getting into private business. That's not its role. But these two GSE's have grown to such a vital role in the housing market that the government may need to see them more as they do the highways and defense of the country. There are some things too big for the government not to be involved.

- Ted Allrich