Q&A: Behind Fannie's And Freddie's Stock Slides

Questions swirling about whether housing financing giants Fannie Mae and Freddie Mac would need a federal bailout sent shares of the two companies tumbling on Thursday. Fannie Mae closed at $13.20, a decline of 13.8 percent for the day. Freddie Mac closed at $8, down 22 percent. Both stocks are at historic lows, with steep declines overall from a year ago — Fannie is down 78.5 percent and Freddie is down 86.1 percent.

The Wall Street Journal reported Thursday that the Bush administration was developing contingency plans for the collapse of the companies. Treasury Secretary Henry Paulson testified on Capitol Hill in an effort to calm investor anxiety about Fannie and Freddie. "They play an important and vital role in our economy and housing markets today, and they need to continue to play an important role in the future," Paulson told legislators. "Their regulator has made clear that they are adequately capitalized."

Mark Zandi, chief economist for Moody's Economy.com and an adviser to Republican Sen. John McCain's presidential campaign, told NPR that the companies may need to issue more shares of stock to raise money. That would dilute the value of existing shares, he said. "Unless you're a shareholder I wouldn't be worried because there is no chance that the federal government would allow these institutions to fail — to stop doing business. It would just be catastrophic for the system, for our economy. It's just not going to happen," Zandi said.

Here's a look at the role the two firms play in the housing market.

What are Fannie Mae and Freddie Mac?

Fannie Mae and Freddie Mac were chartered by Congress as government-sponsored enterprises, or GSEs, which gives them a quasi-governmental status. Both are in the same business: They buy home loans from lenders, then hold them in their portfolios or repackage them into bonds — known as mortgage-backed securities — that are traded on Wall Street. Fannie Mae was created in 1938; its smaller rival, Freddie Mac, was established in 1970.

What role do they play in the housing market?

Fannie and Freddie are the largest buyers of home loans in the nation. As such, they provide liquidity to housing markets. This enables banks, mortgage companies and savings and loans to keep making home loans. Consumers benefit, too: Greater liquidity means there is more money with which financial institutions can make home loans, and they can offer those loans at lower rates.

Fannie and Freddie's role is particularly important nowadays: With the credit market drying up, the firms are often the "buyer of last resort" for a mortgage at a time "when a broad-based buyers' strike threatened to paralyze the markets," says Bruce W. Harting, an analyst at Lehman Brothers, in a research note. Any threat that they might fail, he says, "could trigger a meltdown in credit markets that would make the movements in credit markets that we've seen over the last year look like a modest hiccup."

Why did shares of Fannie and Freddie plunge so far on Monday?

Shares of the two firms have been dropping for months as the housing downturn has worsened. But Monday's slide was prompted in part by a report from Harting in which he indicated that the Financial Accounting Standards Board was contemplating an accounting rule change that would have boosted the amount of capital the two companies have to keep on hand. Fannie would have to add $46 billion to its reserves; Freddie would need to add $29 billion.

The large sums spooked investors, who worried about the firms' abilities to raise that kind of cash in the current tight credit market. And the sell-off began.

Harting's report noted that the changes were "unnecessary." "It's in no one's interest for the GSEs to be saddled with overwhelming capital requirements at a time when the market needs the GSEs to buy mortgages, and when the capital markets and the economy are in very fragile states," he wrote.

Are these companies in financial trouble?

In June, the Office of Federal Housing Enterprise Oversight (OFHEO), the primary federal regulator for Fannie and Freddie, said the two companies were "adequately capitalized" — in other words, they had enough cash on hand to keep doing business.

OFHEO Director James Lockhart told reporters that Freddie and Fannie did not deserve the beating they got in the market Monday. "If you look at the financials of these two companies, how they are prudently growing their books of business ... it was hard to imagine what happened yesterday," he said.

Correction July 11, 2008

An earlier version of this story misstated that OFHEO Director James Lockhart made his comments to The Associated Press. He made the comments to Reuters and other reporters.

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