Following the blow-up of the secondary mortgage market, most wall street firms that had been buying mortgages withdrew from that activity.  That left freddie mac and fannie mae to handle more than 80% of all mortgages during the first quarter of 2008.  Congress had such a backstop in mind when they created these two government-sponsored firms.  There is nothing in writing that requires the federal government to stand behind these two firms if ever they become overwhelmed with losses.  But that has been implied from the start.  Wall street has accepted this as a fact.  That is why these private companies are able to borrow billions of dollars at an interest rate close to that paid by the treasury.

Congress, the treasury and the federal reserve have all rallied around fannie mae and freddie mac since the credit crisis erupted.  They have expanded the range of mortgages that the two companies can buy, allowing them to reach over $700,000 in high-cost markets.  And they have increased the total amount of mortgages they can buy, throwing out the limitations imposed when it was discovered that the companies had been playing games with numbers on their books in order to maximize shareholder values, drive up the price of their two stocks and thus enrich top executives holding large numbers of stock options.  All that was forgotten as the nation looked to these two companies to rescue hundreds of thousands of homeowners caught up in a credit crisis.

But that was last week.  Now the situation has changed greatly almost overnight.  First, the ceos of both companies said some things during testimony before congress that shocked everyone - including the treasury boss and the fed chairman.  The ceos admitted they had defied “suggestions” that they raise more new capital in order to beef up their reserves against possible defaults and foreclosures.  They said they had held back because to do so would have diluted the equity interest of their shareholders and possibly cost them money.  That left the taxpayers exposed for several billions of dollars of losses – and if the failure of the two companies caused a panic collapse in the housing market it would leave taxpayers being forced to cover losses in the hundreds of billions of dollars.

That was just for starters.  Then, under probing questioning, they admitted they had changed their internal rules on when a mortgage is considered at risk of default.  Previously they had listed a mortgage as delinquent and impaired when payments were 120 days behind schedule.  Now new rules allow them to ignore delinquent mortgages until payments are two years behind times.  This created a gap of $19.9 billion of what accountants call “unrealized losses.”  By ignoring this gap, the bosses justified their failure to reach out for more private capital to shore up their financial base.  Again.  This is seen as a deliberate effort to hide their problems behind an opaque screen.  When asked about this, top executives bluntly told congress that they saw their first obligation to be toward shareholders, meaning their prime duty is to keep the value of their stock up.

Federal regulators were mighty unhappy about this statement, because both companies wallowed in profits during the period of alan greenspan’s ridiculously low interest rates.  Record profits for the companies led to awesome gains for investors and king-sized bonuses for executives.  A big problem was that they did not take advantage of this windfall to build reserves against the day when mortgages came down from their unnatural heights of 2004-2005.  This ceo attitude now has federal officials and congressional leaders threatening to impose much stricter regulation on what mortgages these two companies will be able to buy.

The hope is, given their 80% market share, that mortgage lenders of all stripes will be forced to become more selective in the mortgages they write in the first place.  That won’t solve today’s problems overnight.  But fed chairman bernanke, a top expert on what mistakes led to the great depression of the 1930’s, thinks many of the current troubles stem from fear that the mortgage industry is going to implode.  By tightening down on regulations, he feels a normal market can be brought back into sight and that itself will help stabilize housing prices and values.

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