Economists are theorizing about the potential ramifications about Fannie Mae and Freddie Mac. Politicians are eager to find something that appears to be a solution. But does it really make a difference?
Let's say at one extreme Fannie and Freddie disappear. There would be a lack of capital in the mortgage markets and interest rates would skyrocket. Alternately, let's say that all of the mortgages are replaced with government bonds which effectively guarantees Fanny and Freddie's debt. Taxes would need to be raised to subsidize those mortgages. Effectively the result is the same on the average American, either it is more expensive to get a mortgage or taxes are higher.
So how does one make it look like nothing happened so that live goes on as usual?
Well there are a couple of things we can do:
First, we can have some central entity buy mortgages, so that the loan personnel in the local banks carry no risk. This ensures that money is continuously available to provide mortgages mitigating the skyrocketing interest problem I discussed above.
Second, the entity buying the mortgages will need to make money off of them, but individual mortgages carry substantial risk. To mitigate the risk the central entity can chop up the mortgage into $1000 pieces, and combine parts of one mortgage with parts of dozens of others into some kind of security. Now instead of losing a lot if one person defaults, there is a relatively minimal loss. Even in this less than wonderful market 95% of homeowners are able to pay their mortgage.
Third, these entities can be configured to meet the income needs of customers: Some would like regular payments, some like a large payment at the beginning and then smaller ones toward the end, some want more principle than interest up front, etc. Whatever people in the marketplace want the central entity can provide it. Investors can buy these products a la carte and the central entity makes money while sharing the risk with others.
So, what's the problem with Fannie Mae and Freddie Mac?
Well, a small increase in defaults can have a large effect since these companies manage over $5T in debt. A 1% increase in defaults is a $50B loss (granted a lot of people could share that loss), these companies make about $15B a year, so one really bad year can cause a lot of problems for investors. That investor heartache is the source of the current debacle.
To resolve that the government insured the end-investors (who bought the products a la carte) that they would not take a loss due to default, and that the government would insure the end-investors would continue to receive payments as promised. However, this means Fannie and Freddie are going to have a bad year (their investors will pay for the bailout), but your life and mine will go one as it had.