As expected, the US government stepped in today and placed Fannie Mae and Freddie Mac into a conservatorship under federal control. This is the long talked about bailout of the two mortgage giants. This action has been anticipated for a while as both the Fed and Treasury Secretary Paulson announced a month ago that they were ready to stand behind and guarantee any losses. Announcing the guarantees calmed the markets at first, but further losses have now forced the Government’s hand. The new plan means that the Federal Government is not just standing behind Fannie and Freddie, but propping them up completely. They now have virtually unlimited access to capital. This plan will dilute common shares of stock in the companies to the point they are near worthless. Preferred shares (owned mostly by big banks) will still be viable, but a new treasury class of preferred stock (owned by the Treasury) will be issued. This new stock will have first dibs on any profits the company makes, and the stock holders won’t see any dividends until all the money lent from the treasury has been paid back.

By doing this over the weekend (as they did with Bear Stearns several months ago) the intent is to avoid a panic in the markets. The initial response is positive. The Asian markets are rallying on the news as I write this. But the initial reaction is not always the lasting response. It is hard to know how this will play out in the short term, but in the long run this should bring mortgage rates down and be a boost for the real estate markets.

Over the last year the mortgage chicago il market has been nearly frozen. Investors in mortgage backed securities, lacking confidence in Fannie and Freddie being able to stand behind their losses, have avoided mortgage bonds and demanded a much higher premium for those they bought. The spread of mortgages over Treasury bills used to be about a 1% premium, over the last year it has grown to about 3%. All the big banks have huge portfolios of mortgages they haven’t been able to sell. Fannie and Freddie have pulled back and are only taking on the most risk free loans. With the US Government behind it, this will give investors the confidence that if they buy a mortgage bond, they won’t be left holding the bag if Fannie and Freddie go down.

The markets will be volatile this week, but when this all shakes out I expect that it will lead to a more normalized exchange and that the risk premium (the spread between mortgage bonds and treasury bonds) will begin to narrow. That means rates will come down.

This is an unprecedented move, and it puts all the risk of losses on the tax payer’s shoulders. With a combined portfolio of about $5 trillion this is a huge risk, but the risk of doing nothing would be worse. The hope is that over the next 5 years as the real estate market improves, this could actually pay for itself. We will see how it all shakes out, but I think this is a good sign for the real estate market.

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