Last week, share prices for Fannie Mae and Freddie Mac fell drastically on concerns they may lack adequate capital to cover mounting losses from defaulting loans.
Fannie and Freddie hold or guarantee about half the home mortgages in the United States, and if investor worries were to cause these enterprises not to be able to sell bonds to finance new mortgages, the U.S. economy could be cast into the worst crisis since the Great Depression. To avoid that, the government needs to take a more active role - fast - in stabilizing these essential institutions.
That process began Sunday evening, when the Federal Reserve announced it would lend to Fannie and Freddie as it does to banks, and the Treasury will seek congressional approval to increase its standby lines of credit and temporary authority to purchase equity, as needed, to ensure these firms have sufficient capital.
This not a bailout for badly run businesses; it is a reasonable response to a federal failure to adequately regulate banks, which has put these vital institutions at risk. The failure to curb abuses in the subprime sector - such as zero-down loans, zero-interest payment loans and loans with no documentation of income - helped create the housing bubble, which is now causing defaults on well-written Fannie and Freddie loans.
Foreclosure is expensive. When home buyers borrow from banks, they are required to provide down payments to cover losses if they fail to meet obligations. Normally, banks sell repossessed properties below market price and lose months of interest and legal costs. Consequently, banks require down payments of 20 percent or more of the appraised value when they keep mortgages in their investment portfolios.
For most working families, coming up with $20,000 or more to buy a first home is not practical. That's where Fannie and Freddie come in. Chartered by Congress as private stockholder companies, they make homeownership possible with small down payments.
They do this by purchasing low down payment loans from banks and either hold the loans or pool them into bonds for sale to investors, while guaranteeing the interest and principal will be paid. To assume this liability, Fannie and Freddie charge the banks fees that are passed along to home buyers, which vary in size according to the risk.
Generally, Fannie and Freddie buy only prime loans - loans to individuals with solid employment histories and good credit scores - and their default rates are well below those of banks on subprime and other, more-risky, mortgages.
