Washington throws long lifeline

Rescue aims at Fannie, Freddie, and US economy

As Fannie Mae headquarters become a media backdrop yesterday, stock prices of the mortgage giants wobbled but credit markets traded as if the institutions remained on solid footing. (Karen Bleier/AFP/Getty Images)

The federal government's rescue plan for mortgage-market linchpins Fannie Mae and Freddie Mac got off to a promising start yesterday. An open checkbook can still buy a lot of goodwill.

Good thing, too. In 2008, the year of the government bailout, no other federal rescue plan has become more important to the nation's economic health. The modern mortgage system would fall on its face without Fannie Mae and Freddie Mac and home prices would plunge with it.

Late Sunday, the Federal Reserve promised short-term loans for Freddie Mac and Fannie Mae if necessary. Treasury officials pushed a plan allowing the government to buy equity stakes in the mortgage institutions and dramatically increase their existing credit lines.

Markets around the world heard the message loud and clear yesterday morning. The government will make sure the giant institutions that guarantee nearly half the nation's home mortgages continue to function normally, but it won't necessarily bail out shareholders who own Fannie Mae and Freddie Mac. Stock prices of both institutions wobbled, but credit markets traded as if Fannie and Freddie remained on solid footing.

How much credit would Fannie and Freddie get? "It's whatever you need," Representative Barney Frank, the Massachusetts Democrat and chairman of the House Committee on Financial Services, said of the likely increase in existing credit lines. "We hope it won't be anything at all."

But nobody has a clue what Fannie and Freddie will actually need. Both have very real financial problems, but it was crisis of confidence that prompted government officials to act over the weekend. Fear alone can be enough to throw a wrench into the home-loan system.

Fannie Mae and Freddie Mac pump money into the mortgage market by connecting lenders with investors who buy home loans in the form of securities. Fannie and Freddie buy loans, convert them into securities, and then guarantee the face value of the loans for a fee.

The mortgage giants buy so-called conforming mortgages that have always been considered relatively safe, not subprime loans and other riskier kinds of credit. Now those loans are under increasing threats of defaulting.

The great fear is all about the pace and scale of mortgage foreclosures across the country and whether they have the potential to swamp Fannie Mae and Freddie Mac, which have both been losing money. Those institutions still hold about $80 billion in capital between them, but that represents only about 1.4 percent of the loans they guarantee or own directly.

What would happen if Fannie Mae and Freddie Mac were no longer in a position to guarantee the principal of new mortgage loans or stand behind existing securities? "Mortgage lending would dry up almost completely and that would be a disaster for the typical US household," says Nariman Behravesh, chief economist at Global Insight. "House prices would truly collapse."

That's why it was important for government officials to act before Freddie Mac went into the credit market as planned yesterday to raise $3 billion of short-term borrowing required for routine purposes. Before the Fed's actions over the weekend, the stock market was shooting first and asking questions later, nearly cutting the value of Freddie in half the previous week.

Any failure to raise the $3 billion yesterday from balky investors would have sent shock waves through the system. With its government support on full display, Freddie Mac encountered no problems.

Though Fannie Mae's and Freddie Mac's trade in mortgages was always seen as low risk, they have brought a good deal of today's problems on themselves. They grew too big for their own capital cushions, exposed to danger in the kind of real estate downturn no one expected.

Stockholders cheered when Freddie and Fannie made more money. The mortgage firms even bought lots of mortgages for their own accounts, to bulk up and make yet more money. Now, taxpayers may have to pay to clean up the mess. Some people in Washington understandably choke on that, but what are they going to do?

"You can always argue whether Fannie and Freddie are part of the problem," says Tom Pappas of Wellington Management, who manages the $25 billion Vanguard GNMA Fund, the largest mutual fund that invests in mortgage securities. "But it's pretty clear everyone's come together and said they're both part of the solution."

And that's the truth. Government can impose greater regulation and limit some of the things Fannie and Freddie do. But America's economy can't recover without a stable real estate market and money available for qualified buyers to purchase homes. That can't happen without Freddie Mac and Fannie Mae doing the work both homeowners and investors rely upon.

Steven Syre is a Globe columnist. He can be reached at syre@globe.com.