Why You Should Be Concerned About "Fannie and Freddie"

Editor's Note: The federal takeover of Fannie Mae and Freddie Mac has been big news. We sent this alert out when the trouble began for these two mortgage giants so you understand exactly how this flap affects you. Here's why the government bailout needed to happen:

The news is serious: The Federal Reserve and the Treasury Department recently took unprecedented steps to make sure that Fannie Mae and Freddie Mac don't collapse. We're normally not fans of the government stepping in, but this is one instance where it had to – or the consequences could be disastrous for all of us.

Now, we're seeing the effects in the form of higher interest rates, bigger fees and closing costs, heftier down payments and tougher approval criteria that makes it harder to even get a mortgage. Here's how it all affects you:

First, if you own stock in any companies that provide mortgages, you should consider selling. These stocks are taking a beating (Washington Mutual was down 35% the day the news was announced), and it will be a long time before they recover.

If you don't own Fannie Mae, Freddie Mac or other mortgage companies, you may have heard the news and figured that it has nothing to do with you.

Actually, it does. It affects all of us, so we want to be sure you know what the pros can't or won't tell you: The problems with these two government-sponsored entities (GSEs) potentially pose a BIG threat to our collective financial security.

To fully understand what's going on, you need to know what Fannie and Freddie do for a living, so let's start there.

When the Music Stops

Simply put, when you go to the bank for a mortgage, that lender may use money that it has on deposit to make your loan. In other words, money that has come to that bank in the form of savings accounts, checking accounts, CDs, or money market accounts.

The classic movie, "It's a Wonderful Life," is a perfect example of this process.

But, nowadays, the transaction doesn't stop there. Banks would be limited in their mortgage lending ability by the amount of money we customers have invested in the various accounts at the banks. This is where Fannie and Freddie step in to get the loan done.

In fact, Fannie and Freddie have bought almost half of ALL home mortgages issued in this country! That's why the situation is so serious.

Fannie and Freddie raise more money to help the process continue by packaging a bunch of loans together in the form of bonds and then selling those bonds to…you guessed it…investors like you and me!

As long as the homeowners make their mortgage payments on a timely basis, everyone is happy and the cycle continues. But, if too many homeowners start defaulting on their mortgages and their houses go into foreclosure, the music stops. Just like the parlor game, Musical Chairs, the bond investor "caught standing" with the defaulted mortgage is in real trouble.

Next: The Ripple Effect