ANDREA SEABROOK, host:
The federal takeover of IndyMac is a big story, but what's really rocking the financial world are the troubles of Fannie Mae and Freddie Mac. These two companies control much of the country's mortgage market, and they're not doing well. There are rumors of a possible federal bailout. That sent the markets tumbling and Fannie Mae's stock price sank 30 percent this week; Freddie Mac's dove 45 percent.
Now, these companies are huge. Even economists have trouble understanding them. Thank goodness we found one who does - Susan Wachter. She's a professor at the University of Pennsylvania's Wharton School of Business. She was an assistant secretary in the Department of Housing and Urban Development under President Clinton. Welcome to the show, Susan Wachter.
Professor SUSAN WACHTER (Financial Management and Real Estate; University of Pennsylvania, Wharton School of Business; Former Assistant Secretary, Department of Housing and Urban Development): My pleasure to be here, Andrea.
SEABROOK: So, what were these companies created to do in the first place?
Prof. WACHTER: Well, Fannie Mae was the first created and it was invented in response to the major crisis of the Great Depression. A key part of the Great Depression is the banks were unable to lend. They were out of money; there was panic. The housing market was even in far worse shape than it is now because there's no lending.
The government created Fannie Mae, which guaranteed that they would purchase the mortgages that the banks made at the price. So, banks lent out, let's say, $100,000 - of course, it'd be much less then - for a mortgage and if the borrower went into default delinquency, and it was very risky times - they might - the federal government would pay that $100,000 back to the bank.
SEABROOK: Okay. One of the things that's always caused me trouble in understanding this is why there are two. How did Freddie Mac come about?
Prof. WACHTER: Well, Fannie Mae was historically the institution but then we had another crisis.
SEABROOK: We've fast-forwarded here to the 1970s, right?
Prof. WACHTER: Yeah, we have fast-forwarded to the 1970s. There was a crisis of excess inflation. So, out of that crisis, Fannie's brother agency, Freddie Mac, was created.
SEABROOK: So, these are government-created agencies but they're run like private companies, right? I mean, we just said their stock prices tumbled this week.
Prof. WACHTER: Absolutely. They're shareholder-owned; they trade on the New York Stock Exchange, absolutely.
SEABROOK: This isn't the first time they're run into trouble. In the '80s during the Savings and Loan crisis, there was trouble, wasn't there?
Prof. WACHTER: Yes, absolutely.
SEABROOK: Tell me about that.
Prof. WACHTER: Well, they're under some of the same pressures that banks were, and savings and loan as well. Lending long, at a time when interest rates were going up therefore the cost of money is going up. What happened in the '70s, we had a spiking in interest rates and inflation rates to double digits.
So, all entities - financial firms, banks, S&Ls and Fannie Mac - were faced with increased costs of funding. And what do they have in their portfolio? They had securities that had low returns because they had securities that were very long-lived and that had been originated in time of low inflation, low interest rates.
SEABROOK: Tell me about these securities that Fannie Mae and Freddie Mac had in their portfolios.
Prof. WACHTER: So, they are basically pooled mortgages and the cash flow on these pooled mortgages are what borrowers pay in their mortgage payments. These payments are pooled together and paid out to investors. And investors who buy these pooled securities that are guaranteed by Fannie and Freddie are guaranteed by Fannie and Freddie that they will get their principal back.
SEABROOK: So, if people have trouble having their mortgage payments, there's no cash flow, which means the security holders don't get their payments and Fannie and Freddie…
Prof. WACHTER: Fannie and Freddie will step in to make sure that the investors are made whole. They will get their payments.
SEABROOK: But that means that it's not a great time for Fannie and Freddie.
Prof. WACHTER: You've got it.
SEABROOK: And so that's basically the model of what's happening today?
Prof. WACHTER: That's exactly what's happening today. But the real difference right now - from the crisis of the '70s, let's say - the real difference is we have not seen in the United States housing price declines similar to the ones we are facing today since the Great Depression.
SEABROOK: Susan Wachter is a professor at the University of Pennsylvania's Wharton School of Business. Thanks so much for joining us.
Prof. WACHTER: My pleasure.
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