Hawaii Real Estate Reporter

On September 7, the U.S. Treasury took control of failing mortgage companies Freddie Mac and Fannie Mae. In addition to taking over the operation of the two companies, the Government has committed up to 200 billion dollars to keep the companies in working order. Since these two mortgage giants own about half of all home loans in the United States, failure to stabilize these companies would have caused havoc in an already struggling housing industry.

Q: What do Freddie and Fannie Do?

When a lender makes a loan, that lender will not usually keep ownership of the loan. They sell the loan to investors (usually institutions, not individuals) on the “secondary mortgage market”. Freddie and Fannie buy loans on the secondary mortgage market. Freddie and Fannie repackage these loans and sell ownership of them to other investors as “mortgage-backed securities”.

Q: I thought that Freddie and Fannie were public entities, what’s changed?

Freddie and Fannie are private companies that were set up by the government, called “Government Sponsored Enterprises” (GSE). When the Treasury took control of Freddie and Fannie, they took over operations and provided money to help the companies account for their losses. Non-government shareholders still hold stock in the company, so it is not nationalized.

Q: Why does the takeover lower mortgage rates?

Simple Reason:

Freddie and Fannie buy loans from lenders. The government’s takeover of Freddie and Fannie gives lenders the assurance that these major loan purchasers are healthy enough to continue to purchase loans in volume. Since Freddie and Fannie are able to purchase loans, the risk (to the lender) of getting stuck with a loan is lower. Since mortgage rates are calculated largely by risk, lenders are therefore able to lower their mortgage rates.

Not-so-simple Reason:

Mortgage rates are largely determined by the yield (money periodically paid to investors) of mortgage-backed securities. When investors are confident in mortgage-backed securities, they want lower yields, so that the extra money that would have been paid to them in yield gets “reinvested” in the mortgage-backed security. When investor confidence is low, they want the maximum amount of yield money to be paid to them because they don’t want to “re-invest” that money in what they perceive as an “unhealthy” security. When investors are demanding more money in yields, the lending system must compensate for this loss of money by demanding higher interest rates from homebuyers.

The government is promising to buy a large amount of Freddie and Fannie’s mortgage backed securities. Because of this, investor confidence is much higher. Therefore investors will not demand high yields. Because of this, lower interest rates are offered to homebuyers.

Q: Will this drop in mortgage rates last?

The Government’s arrangement with Freddie and Fannie is explicitly temporary – but mortgage rates are expected to increase long before it expires in December 2009.