John W. Schoen Senior producer • Profile • E-mail

The collapse of Fannie Mae and Freddie Mac shares came suddenly this week, as investors fled the two mortgage finance giants over worries they may not have the financial strength to weather the ongoing storm in the housing market. But the problems facing Fannie and Freddie have been building for years.

Those financial problems could, in turn, push the housing market into a deeper decline. The two government-sponsored mortgage companies, which hold a staggering $5 trillion in mortgages and mortgage-backed paper, have emerged as the primary source of funds for home buyers following the meltdown of the subprime mortgage industry.

“Investors have lost total confidence in Fannie and Freddie and are looking for a government bailout,” said Robert Napoli, an analyst who follows the financial services industry at Piper Jaffray. “If Fannie and Freddie have to pull back substantially in their lending, we're taking another leg down in the market and housing prices. There are no other lenders right now in the U.S. mortgage market other than Fannie and Freddie."

The companies, which are nominally private but operate under government charters, buy up mortgages written by other lenders and sell them to investors, freeing up more capital for new loans. With the downturn in the banking industry and the collapse of many lenders, Fannie and Freddie are critical to any prospects for recovery in the U.S. housing market, which is mired in its worst downturn since the Great Depression.

Fears about the fate of the two mortgage lending giants swept through financial markets Friday after published reports that the government was considering a bailout. Shares of big commercial and investment banks also took a hit on worries about the prospect of further losses and writedowns.

Treasury Secretary Henry Paulson sought to calm the markets by saying that the administration's "primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission." That helped boost Fannie and Freddie shares off their lows, although both were still down in late trading.

Fannie Mae shares have lost 80 percent of their value over the past year, while Freddie Mac shares are down 90 percent.

There are several steps the government could take short of a takeover of the two mortgage finance giants. The Federal Reserve could extend credit and promise to stand behind the two companies if they run short of cash — just as the central bank did in March when it engineered the takeover of Bear Stearns. The Treasury also could buy up mortgage-backed securities issued by Fannie and Freddie to shore up that market.

Established in 1938 as part of President Franklin Roosevelt’s New Deal, Fannie Mae was created to get the mortgage market moving again after credit for home buyers dried up during the Great Depression.

Though it gets no federal funding or explicit guarantees, investors have always assumed the government would make good on its debts if it ever got into financial trouble. That implicit guarantee has helped hold down interest rates on bonds issue by Fannie Mae and thus has helped hold down mortgage rates.

Freddie Mac, which operates under similar government charter, was set up in 1970 to expand funding for the U.S. mortgage market.

Concerns about the financial strength of the two entities have been building since the mortgage market began unwinding more than a year ago. Those worries intensified this week after a report that a possible change in accounting rules could force Fannie and Freddie to raise another $75 billion in capital. If they raised that capital by selling stock, that would dilute the value of shares already held by investors. 

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