The Basics: Just what the Heck Are Fannie Mae and Freddie Mac?

By Vince Farrell, Huffington Post. Posted July 14, 2008.

Everyone else is writing about Fannie Mae and Freddie Mac so I figured I would as well. The two companies play a central, indeed, the central role in the mortgage marketplace. They don't make mortgages. They buy mortgages from originating banks and repackage them as bonds or keep them on their own balance sheets. The ones they package and sell are guaranteed by FNM or FRE for a fee. Between the two functions the companies touch over $5 trillion in mortgages. They do this with a far skinnier equity base than any other financial institution. Since they were always considered too big to fail and would be bailed out by the government in a time of trouble they have been able to borrow at lower interest rates than others.

Well, they got in trouble and the government is bailing them out. To oversimplify it, the companies have too little capital to handle the growing number of troubled mortgages they either own or guarantee. Without getting into details, the mortgages they are involved with are not sub prime, and are of generally very good quality. But in tough times even good loans go bad. If you take just the mortgages they own you come to a total of $1.7 trillion supported by core capital of about $70 billion. That is a leverage ratio of 24 to 1. Throw in the guaranteed stuff and you balloon to 68 to 1. You can have a very good book of mortgages with a very low default rate and still be out of business quickly with that leverage. It's lunacy.

The Treasury Secretary announced Sunday night that the companies can borrow from the NY Federal Reserve bank. FNM and FRE have access to the "discount window." They will pledge collateral for the loans. Secretary Paulson also said the government will pursue increasing the existing modest credit line the companies enjoy and will consider an equity investment. I figure the companies will try to raise capital themselves because if the government comes in with equity capital I hope it would be so dilutive as to ruin the existing common.

My guess is that this move buys time. The markets should settle down. A key indicator will be FRE's auction of three and six month paper early Monday morning. It should go off easily, but if it doesn't that would be a sign of big trouble. FRE's three month paper went out at 2.43 percent late Friday.

There are as many estimates as there are news articles this weekend as to what the level of losses might be as the housing market plays itself out. I have read everywhere from $20-30 billion to $100 billion. $20-30 billion the companies can handle. $100 billion needs a slug of capital, but the truth is no one really knows. I will mention that in the midst of Friday's chaotic marketplace, Smith Barney recommended buying both stocks. And, the Savings and Loan debacle of the late 1980's and early 1990's cost the government more than $100 billion. Not to minimize anything but there are solutions and "This too shall pass."

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Vincent Farrell, Jr. is a Principal of Scotsman Capital Management LLC.