Mortgage meltdown

September 8, 2008 | By Kevin G. Hall, McClatchy Newspapers

WASHINGTON — The historic seizure of mortgage-finance titans Fannie Mae and Freddie Mac is expected to bolster the nation’s sinking housing sector by lowering mortgage rates and jump-starting the obscure background market that is vital to home lending.

Here are some answers to what the plan does and how it affects American homeowners.

Q: How do Fannie and Freddie impact mortgage finance?

A: They buy mortgages from commercial banks and other home lenders, then package these pooled mortgages and sell them into a secondary mortgage market as bonds, called mortgage-backed securities. This process is called securitization, and it allows banks to pass on the loan and not keep it on its own books, freeing its balance sheet for more lending.

Q: How does this help homeowners?

A: It helps in a broader sense. Since Fannie Mae and Freddie Mac own or back more than half of U.S. mortgage debt, anything to stabilize them helps the broader financial markets. In recent months, investors have demanded higher returns in exchange for buying Fannies and Freddies. That led to a widening spread, or gap, between these bonds and, say, a 10-year Treasury bond. Mortgage rates take their cues from long-term U.S. government bonds, so it has had the effect of driving up mortgage rates. Since a Fannie or Freddie will now effectively be government-issued debt, the gap should narrow and rates fall. A drop of 1 percentage point in rates equals about 15 percent savings during the loan’s life.

Are Fannie and Freddie

going bust?

No. Fannie and Freddie will operate as normal but under conservatorship, a process similar to Chapter 11 bankruptcy, in which a business restructures its operations. But investors who purchase mortgage-backed securities — banks, investment funds and even foreign central banks — grew more concerned as more Americans fell behind on their home payments, especially people with good credit.

But they could run short of cash?

That would be unlikely but not impossible. And Paulson believed it better to get out in front of a problem than wait for it to occur. Already, big investors such as Pacific Investment Management Co. the world’s biggest bond fund, were frowning on buying Fannies and Freddies unless the government took bolder action.

So will the housing slump end because of Paulson’s plan?

It won’t end just like that. Mortgage rates are just one part of the equation. But given the erosion in home prices, lenders remain reluctant to lend and have tightened credit sharply. Low rates won’t mean much if banks won’t lend. And the other half of the secondary mortgage market that doesn’t involve Fannie and Freddie is run by the private sector — termed private-label mortgage-backed securities. This part of the market is frozen over like tundra.

Then what’s the significance of the Treasury action?

It assures that the functioning part of mortgage finance, while facing challenges, continues to operate smoothly. Paulson himself spelled out why it’s important to average Americans that turmoil in financial markets not be allowed to spread.

Americans should be confident that the actions taken today will strengthen our ability to weather the housing correction and are critical to returning the economy to stronger sustained growth in the future, the White House said.