Fannie and Freddie 101
Here's how the two mortgage giants became wards of the federal government.
NEW YORK (CNN) -- Call it a bailout, or a rescue, Fannie Mae and Freddie Mac are now firmly under the grip of the U.S. government.
The widely anticipated move was the logical next step as the housing crisis continued to erode the two mortgage giants.
"We have determined that it is necessary to take action," Treasury Secretary Henry Paulson said Sunday. "Our markets will not recover until the end of this housing crisis. Fannie Mae and Freddie Mac are critical to turning the corner on housing." (Paulson's statement)
And with that, the U.S. government took control of sister companies Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), two massive public companies at the heart of the nation's mortgage system. Together, Fannie and Freddie own or guarantee more than half of the U.S. mortgage market - that's more than $5 trillion in loans.
Here's how they work: Banks loan money to home buyers. The banks then sell those mortgages - assuming they meet certain credit standards - to Fannie Mae or Freddie Mac.
Banks then use the money they get from the sale of those mortgages to make new loans. Fannie and Freddie, meanwhile, bundle those loans, attach a payment guarantee to them, and resell them as bonds.
"They might issue the mortgage on Monday and sell it in the secondary market to Fannie and Freddie on Tuesday, and then Fannie and Freddie is putting it together in a mortgage backed security, selling it a week, two weeks later," said Dean Baker, an economist who is co-director of the Center for Economic and Policy Research in Washington. "So they're incredibly important institutions."
The system provided a continuous supply of relatively low-interest cash, allowing banks to keep making affordable loans to home buyers.
But as home prices dropped, mortgage defaults soared, making it harder for Fannie and Freddie to raise money.
"The interest rate that Fannie and Freddie had to pay began to rise and of course that gets passed on in higher mortage rates to anyone who goes to buy a home," said Baker.
So, in an emergency move in July, Paulson said the government stood ready to provide direct financial support to Fannie and Freddie, if needed. He said he hoped it wouldn't be needed.
"If you've got a squirt gun in your pocket, you may have to take it out," Paulson told the Senate Banking Committee on July 15. "If you've got a bazooka, and people know you've got it, you may not have to take it out."
But without an "explicit" guarantee from the U.S. government, the stock of both companies continued to drop, and major investors - including the central banks of Russia and China - started selling Fannie and Freddie bonds fast. That made it harder, and more expensive, for Fannie and Freddie to raise money.
That guarantee that investors wanted is now explicit. The U.S. government is now in the business of buying and reselling mortgages, and Paulson and his cohorts hope that sends the message that Fannie and Freddie are safe.
Under the best-case scenario, the cost of a 30-year mortgage could start to drop - maybe as much as a third of a percentage point, and that could encourage more home sales.
The bad news - taxpayers could get stuck with a $200 billion bill for the bailout.