End of Credit Crisis in Sight - Freddie Mac & Fannie Mae nationalized

The Credit crisis which has roiled the markets for over 2 years is now hopefully nearing an End with the near-nationalization of the US Secondary Mortgage Market Majors - Freddie Mac and Fannie Mae, yesterday. This action has fed a lot more confidence into the credit markets reeling from the subprime crisis.

The US mortgage market is structured in such a way that, you have the primary lenders (banks like Wells Fargo etc) who make loans to individuals for the purpose of housing. However, these mortgages run into hundreds of thousands of dollars. So a normal lender can only give so many mortgages, before his cash flow is completely stuck in these extremely long-term (upto 30 year long) loans. So to add more liquidity to such a market, the US Govt established the Freddie Mac in c1970, which would buy the loans (at its discretion) from these primary lenders. Having got back their initial capital, the primary lenders can provide other people loans. Freddie Mac in turn pooled and securitized (oversimplification:bundled) these loans and sold the resulting securities to investors in various organizations. Freddie Mac, guaranteed the rate of interest on these securities and hence assumed the credit risk, for which it charged a fee. Essentially, this means that any non-payment of mortgage by a person, will be made good by Freddie Mac. Fannie Mae is also essentially similar, except for its beginnings. Between themselves, these organizations own over 50% of all home loans in the US.

Technically these organizations were supposed to be Government Sponsored Enterprises, but essentially private corporations owned by stock holders, without any Govt insurance for their loans. However, due to their size and presumed US Govt backing, they had acquired the tag of "Too big to fail", as in, if they fail, they would drag down the economy with them. This caused them to take up riskier mortgages from the primary lenders. At last count, Both Freddie and Fannie had over $12 Trillion exposure to the mortgage market.

Now that the Subprime crisis has precipitated a downturn in the US housing market, this downturn has resulted in a lot of mortgage defaults (although Freddie Mac does not buy subprime loans), which caused Freddie & Fannie to declare losses of nearly $15 billion last year. This has led to their credit rating dropping to Junk status, forcing the premium on loans to them (bonds) going over 2.5%, making it very difficult for them to raise much needed new capital.

To alleviate the crisis, the US Congress in July passed a law, with bi-partisan support, allowing the US Govt to step in and bail out these corporations if required. This was supposed to give confidence to potential lenders that their loans to Freddie would not go bad (thereby reducing the risk and hence premiums on the bonds). But this action backfired badly, since people know that any such nationalization would wipe out Freddie's stock value. This caused its share price to plummet to less than $5. This precipitated a crisis, forcing the Govt to act immediately and nationalize them both. As expected, Freddie Mac shares dropped to less than 25 cents.

So now the US taxpayers are "bailing" out these corporations. The impact of the bailout is not completely known, and is supposed to be in tens of billions of dollars, if not hundreds of billions. This will also cause tighter regulation in the housing markets, with people having even prime credit ratings facing difficulty to make a mortgage. The US treasury bills have also dropped.

On the brighter side, however, markets are very optimistic over the measure since the credit markets will now be more liquid, stock of various banks which gave loans to Freddie (like Citi Group) have gone up a lot, the premiums have also dropped on mortgages. The last one will once again hopefully rejuvenate the housing sector, which makes up over 25% of the US economy. So overall the housing sector can recover from the glut of unsold inventory, and once again start growing. These will also help to reduce the effects of the current recession the US economy is undergoing.