- The Washington Times - Friday, September 12, 2008

Most readers undoubtedly have heard about the federal government’s takeover of mortgage giants Freddie Mac and Fannie Mae. While many in the media are lamenting the decision as another costly government bailout, I thought I would take this opportunity to explain what it all means and how it could affect the average American.

First, let me explain what Fannie Mae and Freddie Mac do, as many folks have no idea. They are nicknames for the Federal National Mortgage Corp. and the Federal Home Loan Mortgage Corp. Both of these companies were chartered by the federal government with a design to provide mortgage money to as many Americans as possible. Here’s how these companies work.

Before the establishment of Fannie and Freddie, Americans would obtain their mortgages from local banks and so-called building and loan associations. These banks would take savings deposits, pay out an interest rate and then turn around and lend mortgage money to homeowners at a higher interest rate.

The problem is that a bank would run out of money to lend because it had a limited amount of savings deposits from its customers. Enter Fannie Mae and Freddie Mac.

Fannie and Freddie would purchase the loans from the bank, freeing up cash so the bank could make new loans. Fannie and Freddie then would package their loans into mortgage-backed-securities and sell them to investors. Investors would enjoy a nice return on an asset that was collateralized by residential real estate.

Fannie and Freddie established underwriting standards that each loan applicant must meet. It is the lender’s responsibility to ensure that each loan applicant meets Fannie’s and Freddie’s criteria or risk having the loan be rejected for purchase.

This arrangement worked quite well for many years. As interest rates dropped and property values rose beginning in the 1990s, Fannie and Freddie relaxed their guidelines and began to offer so-called Alt-A mortgages. Those programs carried slightly higher rates and were offered to folks who didn’t quite fit the conventional guidelines.

Meanwhile, direct lenders and Wall Street investors teamed up to offer subprime loans. Those carried far higher rates and were offered to folks with no down payment and poor credit. Lenders and mortgage investors didn’t worry because property values kept rising. If the borrower got into trouble, he simply could sell his house, pay back the mortgage and take a profit.

Am I painting the picture of a train wreck waiting to happen?

Here’s the perfect storm: Property values fall, subprime loan holders owe more than the properties are worth, teaser interest rates expire, and balloon payments come due. Delinquencies and foreclosures rise, and mortgage investors get stuck with the hot potato.

Once Wall Street got burned, it lost its appetite for mortgage-backed securities, creating the credit crunch. Meanwhile, Fannie and Freddie get stuck with mortgage paper they can’t sell during a period of skyrocketing delinquency and foreclosure rates.

One of the byproducts of this mess is a combined loss of $14 billion for Fannie and Freddie in the past year.

So the Feds decide they had better spend some taxpayer money and prop up these two giants to avert an economic catastrophe. No one really knows how much the bailout will cost the American taxpayers, but the consensus is it depends upon Fannie’s and Freddie’s financial performance in the coming years.

What does this mean for future homeowners and those who want to refinance their loans? As part of the bailout, the Treasury Department has agreed to purchase Fannie’s and Freddie’s mortgage-backed securities in the open market, alleviating the credit crunch.

It also should bring down mortgage rates. It’s anyone’s guess as to how low rates may go, but rates dropped about three-eighths of a percent in the first day after the announcement.

If the trend continues, potential home buyers will see more affordable housing and homeowners will be able to save some money by lowering their interest rate through a refinance.

  • Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail at henrysavage@pmcmortgage.com.
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