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2009-09-07 10:33:04
By Greg Wood
BBC North America business correspondent
Fannie Mae and Freddie Mac sound like a homely mid-Western couple - dependable,
perhaps slightly dull.
But these two almost destroyed the US housing market and their downfall was the
overture to the global financial crisis.
CRISIS TIMELINE 2008
On 7 September 2008, these giants of the financial world had to be nationalised
by the US government.
Fannie Mae was a child of the Great Depression.
The Federal National Mortgage Association was set up in 1938. A government
agency, its job was to buy home loans from mortgage providers.
The mortgage providers would use the money they received from Fannie Mae to
make more home loans. Freddie Mac, set up in the late 60s, did the same thing.
But once Fannie and Freddie held all these mortgages on their books they had to
do something with them.
Slice and dice
The answer was "securitisation". It's a process which works a bit like a layer
cake.
You stack up all the mortgages horizontally and then slice them vertically.
Each slice contains a little bit of all the mortgages in the "cake" and can be
sold on the financial markets as a "security" - an investment like a share or a
bond.
But there was a flaw in the model.
If a sufficiently large number of homeowners defaulted on the underlying loans,
then the value of those mortgage-backed securities would collapse.
Fannie Mae and Freddie Mac would also be landed with the - very large - bill
for the mortgage repayments.
Turning bad
That's what began to happen when the US housing bubble burst in 2007.
It was the first in a series of crisis Sundays as the US government grappled
with a cascade of financial disasters
Millions of people defaulted on their home loans. The value of mortgage-backed
securities began to fall.
So too did the share prices of Fannie Mae and Freddie Mac.
Both organisations were incurring massive losses - $14 billion in the 12-month
period up to September 2008 - as they paid out the guarantees on millions of
bad home loans.
This put them desperately in need of new capital to fill the hole in their
balance sheets.
But Fannie and Freddie had lost so much in the housing market that private
investors were unwilling to provide the new money they needed.
They were on the brink of bankruptcy.
Falling giants
That event had the potential to trigger a collapse in the global financial
system.
Fannie and Freddie, by this time privately owned, were the two biggest
financial institutions on the planet.
Their bonds and securities were held by investors around the world, including
many governments.
Together they owned or guaranteed half the mortgages in the United States - a
staggering $5 trillion in home loans.
Fannie and Freddie were then responsible for financing 80% of all new mortgages
in the US.
If they went bust it would be almost impossible for anybody in the States to
get a home loan.
Fateful weekend
This was the situation facing the government as it entered the weekend of 6 and
7 September a year ago.
By the Sunday, the fateful decision had been made and Hank Paulson strode down
the steps of the Treasury Department building in Washington DC like some
prophet of doom with his gaunt expression and whispering voice.
The condition of Fannie Mae and Freddie Mac posed a "systemic risk" to the
entire financial edifice, he told the nation.
They could not continue in the present state, so the government was taking them
into "conservatorship".
In plain language, these twin pillars of the mortgage market were being
nationalised.
It was the first in a series of crisis Sundays, as the US government grappled
with a cascade of financial disasters in the hope of resolving them before the
markets re-opened for business at the start of another fraught week.
The nationalisation of Fannie Mae and Freddie Mac was supposed to draw a line
under the financial crisis.
Instead, it merely acted as a prelude to the far more shocking events that were
soon to unfold before an astonished world.