'Sub-Prime Crisis: After Effects' for Dummies

History:

1930s Great Depression

Collapse of the national housing market discourages private lenders from from investing in home loans.

1938 US Housing Bill signed

Fannie Mae, nickname for Federal National Mortgage Association established as an US Government organization in 1938 as part of Roosevelt's US Housing Bill to buy up mortgages and sell them on to investors. The idea was to raise levels of home ownership and the availability of affordable housing. Thus building a secondary mortgage market. 

1968  Private company with a direct credit line from the US Treasury

Under pressures created by the Vietnam War, Lyndon B Johnson privatizes the lender to remove it from its accounts. Fannie starts operating as a Government Sponsored Enterprise (GSE) thus generating profit for its stockholders with a special claim for government assistance in case of any financial trouble. Being a GSE, ensures that Fannie Mae has a direct credit line from the US Treasury, exemption from State and Local Taxes and SEC oversight.    

1970 Monopoly to Duopoly 

To end the monopoly of the Fannie Mae, Federal Home Loan Mortgage Corporation - Freddie Mac was set up as a competitor. Another GSE.

2003 Financial Accounting Scandal

Investigations by Justice Department and SEC into Freddie Mac's accounting practices reveals errors of $4.5 billion. 3 top executives forced to quit.

2007 Sub Prime Mortgage Crisis

Hits the US Housing market.

2008 US Government Bailouts

Loses 74% shareholder value of investments on escalating concern that Fannie and Freddie do not have enough capital to weather the subprime debacle. 

Stats:

• Fannie Mae and Freddie Mac control 90% of US secondary mortgage market.
• Combined current assets is 45 % greater than that of US's largest private bank (Citigroup)
• Combined current debt is 46% of current US national debt. 
• $3+ trillion of debt and guarantees
• $800 billion of junky mortgages  
• China holds $376 billion of long term US agency debt and most of it is in Fannie and Freddie asset. 

The Economic Cycle - Vicious or Virtuous ? 

Virtuous Cycle?

• Local bank disburses loans with low down payment and fixed interest rate. 
• Freddie and Fannie buys mortgages from local banks, securitizes them and sells them as bonds to investors.
• Freddie & Fannie as GSEs operate as private enterprises with US government guarantee of backing in case of financial trouble. Thus their securities are as good as US government securities.
• Being least risky of securities due to US government backing, these securities have high liquidity.  This allows them to have low yield.
• Freddie and Fannie makes profit from the difference in the interest rates charged to borrower and interest rates serviced to the investor to their securities. 
• Due to the direct line of credit from the US Treasury a major buyer of their securities are foreign governments and central banks to hold their foreign reserves. 

 Vicious Cycle?

• Post the the subprime debacle, there is a growing concern amongst investors ( Foreign central banks) about Freddie and Fannie's ability to service their securities.
• Liquidity of these securities decreases resulting in increased risk thus raising the interest rate of borrowing of these securities.
• Interest rate of mortgages increased subsequently.
• US Housing market busts.
• Bad debts for such mortgages run into $800 billion.
• Concern amongst invertors continue to escalate and the vicious cycle of bad debt continues.

To break out out this vicious cycle US government bails out these secondary mortgage company as a measure of reassurance to the investors .