Freddie and Fannie - the Morning After

On Sunday, the federal government took over the management of Freddie Mac and Fannie Mae. Yesterday, the financial markets responded with hyperbolic glee. Pronouncements were made claiming this would save the real estate industry and, on Wall Street, stocks shot up over 300 points.

But today is the day after. And, in the light of this new dawn, people are starting to ask whether we really have our financial White Knight. Is this takeover going to save us? In a word - no. Will it help? Yes. Here's why.

Fannie Mae and Freddie Mac buy loans from banks and package those loans as mortgage-backed securities which they then sell to investors. By purchasing the loans from banks, the banks get their capital back which they then can use to make more loans. This cycle of lending money, selling the loan, and relending the money keeps funds flowing through the banking industry. In other words, there is money available for you to borrow. So what happened?

As concerns began to surface about sub-prime loans and higher-than-normal default rates, investors got nervous. They began to question the quality of the mortgage-backed securities that Freddie and Fannie were peddling. And then they started to question whether these mortgage giants would fail. Many stopped buying the securities and money stopped flowing through the system. Simply put, the money well dried up. That's why, for the past few weeks, even borrowers with great credit and good down payments were having a hard time finding money to borrow. And the money they did find was expensive.

Freddie and Fannie were on the verge of failing. And if they failed, the US financial industry would sustain a mortal wound. Fannie and Freddie are involved in $5.4 trillion worth of mortgage debt. Simply put, they are just too big for the government to allow them to collapse.

So the feds designed a bail-out. They replaced senior management and agreed to purchase $5 billion in Freddie and Fannie mortgage-backed securities. By keeping the companies solvent they are trying to restore faith in the system. They are trying to calm investors' nerves so that mortgage money will, once again, be available.

This will help some of us. Funds will be available to borrow, and the cost of borrowing will probably go down marginally. But it will not help people who have poor credit or a low down payment, so-called "A- or B paper" borrowers. It will not help people who do not have the equity in their homes to refinance before their interest rates increase.

Sunday's move was just a first step - a tourniquet to stop the heavy bleeding so that the patient did not die. It was not a cure. Over the next few months, you can expect to hear lots of opinions coming out of Washington and Wall Street as to what to do next. You can bet that, as with any serious illness, the cure will be long, painful and expensive. And the US taxpayer gets to pay the bill.