How the Fannie and Freddie takeover affects you

By Bankrate.com

Mortgage rates fell abruptly Monday, a day after the federal government announced that it was taking control of home lending giants Fannie Mae and Freddie Mac.

Rates dropped about a quarter of a percentage point early Monday, and had fallen roughly another quarter of a percent my midday. That brought the 30-year, fixed-rate mortgage down to around 6%, its lowest in five months.

Economists, bankers and mortgage brokers had expected mortgage rates to drop, but not as much as half a percentage point. In times of volatility, rates can plunge and then rapidly bounce back.

Mortgage rates fell because investors went on a buying spree Monday for mortgage-backed securities, or MBSs. That caused the prices for these bond-like financial instruments to rise -- and when bond prices rise, yields fall. Mortgage rates followed yields downward.

Mortgage-backed securities found willing buyers because they now are backed by the U.S. Treasury. They are seen as very safe investments now, with attractive yields. Plus, investors have been reassured that the Treasury will buy mortgage-backed securities in the future, so investors don't have to worry about getting stuck with a pile of bonds that no one wants.

• Video: The impact on the housing market

The government takeover of Fannie Mae and Freddie Mac was designed to put downward pressure on mortgage rates and to ensure that home loans remain available.

Those goals were made crystal clear in the statements made by public officials.

The primary mission of the two mortgage giants "now will be to proactively work to increase the availability of mortgage finance," says James Lockhart, who will temporarily govern Fannie and Freddie.

Lockhart, head of the Federal Housing Finance Agency, adds that his agency will examine Fannie's and Freddie's fees "with an eye toward mortgage affordability."

Treasury Secretary Henry Paulson said the government has three objectives: "market stability, mortgage availability and taxpayer protection." That's another signal that the government wants mortgages to remain available, at good rates, to borrowers with a low risk of default.

Fannie Mae and Freddie Mac don't lend directly to consumers. They buy mortgages from lenders, supplying those lenders with money to extend yet more home loans. A halt in this flow of money, even if it lasted but a day, would cause havoc in the global financial system. The federal government's takeover prevents such a financial catastrophe.

Government backing now explicit

Fannie and Freddie guarantee the mortgage-backed securities that they issue, and those securities are deemed quite safe as investments. Not as safe as Treasury notes, but relatively safe. Fannie and Freddie are government-sponsored enterprises, or GSEs, and for decades they had implicit government backing. That backing is now explicit.

"The good news for the consumer is that money will still continue to flow, provided you have the ability to qualify," says Jim Sahnger, a mortgage broker with Palm Beach Financial Network in Stuart, Fla.

• Readers talk: Fannie-Freddie takeover is a disaster

When investors buy bonds, they have a wealth of choices. They can buy U.S. Treasury bills and notes, or corporate debt, or bonds from state and local governments. Or they can buy mortgage-backed securities, which behave much like bonds. Mortgage-backed securities are known as MBS in industry shorthand.

Fannie and Freddie guarantee the mortgage-backed securities that they issue, and those securities are deemed quite safe as investments. Not as safe as Treasury notes, but relatively safe. Fannie and Freddie are government-sponsored enterprises, or GSEs, and for decades they had implicit government backing. That backing is now explicit.

In the past few months, investors have rushed to the safety of Treasury notes and haven't been as eager to buy mortgage-backed securities. The lessened demand caused the prices of mortgage-backed securities to go down. When bond prices fall, bond yields rise, and that's what happened with mortgage-backed securities. As yields went up, so did mortgage rates. The difference, or spread, widened between Treasury yields and mortgage-backed securities.

Now that the Treasury will buy mortgage-backed securities, their prices should rise because of the greater demand. (The same thing would happen if the federal government bought, say, boxcar loads of sugar. You would expect sugar prices to go up.) When bond prices rise, yields drop -- so mortgage rates should follow.

Beneficial to some, but not all

Lockhart, whose department will run Fannie and Freddie, describes this succinctly when he says, "As the GSEs have grappled with their difficulties, we've seen mortgage rate spreads to Treasurys widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. (The) Treasury will begin this new program later this month, investing in new GSE MBS."

The government's action will have a beneficial effect on some mortgages, but not all. It will have little or no impact on jumbo mortgages -- home loans for large amounts. (The definition of a jumbo loan varies, depending on house prices in each metro area. A jumbo is a loan of more than $417,000 in much of the country, and is higher in more expensive housing markets -- up to $729,750 in places such as Los Angeles.)

Because jumbo mortgages are perceived as riskier, their rates have been unusually high for the past year. Historically, jumbo rates had hovered about a quarter of a percentage point above the rates for mortgages backed by Fannie and Freddie. Now they're about a full percentage point higher, and that gap is unlikely to narrow soon.

The government's bailout of Fannie and Freddie won't affect rates on home equity loans or home equity lines of credit, either.

This article was reported and written by Holden Lewis for Bankrate.com.