Concerns about the financial stability of housing finance giants Fannie Mae and Freddie Mac — and whether they might need a federal bailout — have sent shares of the two companies tumbling.
The two firms, which have a quasi-governmental status, were chartered by Congress to help make money for home mortgages more readily available. Together they hold or guarantee about $5 trillion worth of mortgages, making them key players in the nation's housing market. As credit markets have dried up, Fannie and Freddie have played a pivotal role in keeping mortgage markets afloat. The fear is that the failure of one or both would wreak havoc on the nation's financial system — and the broader economy as well.
Here, a look at concerns about Fannie and Freddie.
Why are investors so worried now about Fannie Mae and Freddie Mac?
Fannie Mae and Freddie Mac are the largest buyers of home loans in the nation. 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.
But the big thing they do is guarantee all the loans that they sell to investors. So if a homeowner defaults on a mortgage, Fannie and Freddie will step in and make good on the loan. Right now, they are guaranteeing trillions of dollars' worth of loans.
Of course, now homeowners are defaulting and being foreclosed on at alarming rates, so Fannie and Freddie are being forced to make good on those guarantees to investors. Already they've posted combined losses of $11 billion, and investors are worried there's much more to come.
How much financial trouble are the firms in?
Fannie and Freddie are clearly suffering from the problems in the mortgage industry, says William Seidman, publisher of Bank Director magazine and former chairman of the Federal Deposit Insurance Corp.
"At the present time, from all we know, they are not insolvent, but they are certainly weakened," he says.
On Thursday, the agency that regulates Fannie and Freddie — the Office of Federal Housing Enterprise Oversight — said the two companies had enough cash on hand to keep doing business. Treasury Secretary Henry Paulson agreed.
What sparked the sell-off in shares of Fannie and Freddie?
Shares of the two firms have been dropping for months as the housing downturn has worsened. This week's slide was sparked in part by a report from Lehman Brothers analyst Bruce W. Harting. He warned that a proposed accounting rule change would require the two companies to keep a lot more capital 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. Then later in the week, a former Federal Reserve governor, long a critic of Fannie and Freddie, said they were already insolvent, and he urged the government to take them over. Of course, if the government takes over, shareholders are likely to get nothing, so investors have been scrambling to sell their shares. Both stocks are at historic lows, with steep declines of more than 80 percent from a year ago.
So is a government bailout likely?
Some analysts say a bailout is unlikely and that in any event, it shouldn't be hurried. They say there's still time for Fannie and Freddie to raise additional capital. Others say the time to act is now, before things get even worse.
On Friday, Secretary Paulson signaled that a government takeover wouldn't be necessary, saying that Fannie and Freddie should continue as shareholder-owned companies.
What if Fannie Mae and Freddie Mac failed?
Fannie and Freddie's role is particularly important nowadays: With the credit market drying up, the firms have often been the "buyer of last resort" for a mortgage at a time "when a broad-based buyers' strike threatened to paralyze the markets," Lehman Brothers' Harting writes in a research note. Any threat that they might fail, he says, "could trigger a meltdown in credit markets."
William Seidman adds that if the two firms' guarantee was considered "no good," it would result in "huge losses throughout the world" among financial systems that own their bonds and hold their guarantees.
What about the practical effect on the housing market if these mortgage giants were to go under?
If they went out of business, it would totally disorient the private housing markets, Seidman says. "It would be as close to a disaster as I can think of," he says. "If they could no longer package and guarantee mortgages, funding availability for housing in the United States would be drastically reduced."
I'm still not clear on this: Does the government back these loans?
Well, the law that created Fannie and Freddie explicitly says the government does not guarantee the loans. But many government officials have said that Fannie and Freddie are too important to allow them to fail. New York Sen. Charles Schumer (D), chairman of the Joint Economic Committee, has said that "it would be devastating to the economy" if Fannie Mae and Freddie Mac went under. If they need additional support, he said, "the federal lifeline has always been there."
Compiled from NPR staff reports. The Associated Press contributed to this report.