Many months ago I was a guest on Larry King’s show. At that time I told Larry I was feeling pretty good that the worst of the financial downturn was behind us. But I made it clear that the one thing that would make me worry was if there was another big government bailout like what we had just seen with Bear Stearns.

Well my friends, as you know, that just happened. On Sept. 7th the government announced it had effectively taken control of Fannie Mae and Freddie Mac and was instituting a bunch of changes to shore up the two agencies. Fannie and Freddie either own or guarantee about $5 trillion in U.S. mortgages; that represents about 50% of the mortgage market. The ongoing meltdown in home values had a huge impact on how Fannie and Freddie do business (down below I explain in detail how Fannie and Freddie work). And when you have a hand in 50% of the market and you come down with a flu, everyone else starts feeling sick too. What happened is that Fannie and Freddie’s troubles were not only causing big problems in the housing and credit markets, but were having a huge negative impact on the financial markets. Not just here, but worldwide.

So that’s why both Fannie and Freddie are now officially in conservatorship. The fact that the government is now running the shows means both entities are protected by the full faith and credit of the U.S. government. That will calm financial markets around the globe. The one hitch? Well, guess who provides all the money for that full faith and credit? Yep, it’s us. Once again, it’s taxpayers that will pay to clean up the mess. No one can say exactly how much this bailout could eventually cost U.S. taxpayers, but it is likely to dwarf the $29 billion bailout of Bear Stearns.

There are also other ways in which the bailout could cost you plenty if you aren’t paying attention. Here’s the Suze Scoop on what the Fannie/Freddie bailout could mean to you:


Banks at Risk

Even though Fannie and Freddie were qovernment-backed operations, they pretty much ran like any for-profit corporation; both were publicly traded stocks on the New York Stock Exchange. As part of the bailout, shares of both firms will be worth little to nothing; investors in Fannie and Freddie stock have taken a huge hit. And it turns out that some banks were investors in Fannie and Freddie stock. You need to realize that until recently both stocks were considered big stable firms that provided a nice dividend payout to investors; especially those who owned the “preferred” shares. That’s just the sort of stable investment a bank would want to make.

But that was then. Now, those banks are staring at big losses in their stakes in Fannie and Freddie. There is concern that some smaller banks could be in financial trouble because of the decline in value of their Fannie and Freddie shares. So here’s what really matters to you my friends: I want you to make sure that every bank you have an account with is insured by the FDIC. Most banks are; you can check online, call up customer service or drive by the bank and look for the FDIC sticker that is affixed to the front door. If your money is deposited at an FDIC insured bank your money is 100% safe as long as you follow certain rules. If you have less than $250,000 (new limit as of October 2008)* on deposit at any one bank, you are guaranteed to receive every penny back if in fact the bank runs into financial trouble. Your money is 100% insured by the FDIC; you have absolutely nothing to worry about.

If you have more than $250,000 (new limit as of October 2008)* at any one bank I want you to review my previous Suze Scoop (What you need to know about FDIC Insurance) where I explain the rules for determining whether larger deposits are fully insured by the FDIC. Remember, some depositors at IndyMac, the biggest bank failure so far this year, are now being repaid just 50 cents for every dollar they had on deposit because they didn’t understand the FDIC rules for large balances.

Important note: Though the common stock and preferred stock of both Fannie and Freddie have taken a huge hit, the bonds of both entities will not be hurt in the bailout. In fact, the government’s plan is to fully back the debt of both Fannie and Freddie. So if you happen to own a mutual fund or ETF that invests in Fannie and Freddie debt, you can relax. Please read that carefully I said Fannie and Freddie DEBT not common or preferred stock. 


“Credit Worthy” is being Re-Defined.

While there are many factors that have contributed to the current financial crisis, there is no questioning that lenders became way too lax in terms of their “qualifiying” rules. Just about anyone could get a mortgage-with no down payment!-or credit cards, or a car loan.  Qualifying rules are already changing, and will keep getting tougher in the months ahead. To be honest, this really isn’t a new development, but more a return to old practices. What is changing is that the crazy days are over. To get a loan or credit will require having a solid financial record. If you have a low FICO credit score (below 680 or so) you will find yourself either denied, or the lender will only give you a deal if you agree to pay high interest rates and fees.

Your current credit could also be affected by the return to sanity. If you have a shaky financial record, credit card lenders may reassess whether they really want to do business with you. You could see your card pulled, or the terms may change. If you have a HELOC and live in an area where home prices have been hard hit you could face the lender rescinding the credit line, and possibly even requiring you to speed up repayment of any outstanding balance if your equity has dropped below the line’s original level.

The upshot to all this is that now, more than ever, you need to get your financial house in order. Pay down your credit card balances, work hard to reduce your HELOC debt. Same goes with car loans; push yourself to pay them off. If you reduce or eliminate these debts you don’t have anything to worry about in terms of lenders springing new rules on you. That’s the big scoop here: With so much financial turmoil in the world right now, the best way to protect yourself is to get out of harm’s way. Just as smart people evacuate their homes before a hurricane bears down, so too should we all make sure we aren’t in the path of any oncoming financial storm. There is so much going on in the world that is beyond our individual control, but cleaning up your financial balance sheet is all within your control. So focus on what you can control and change. Shore up your financial house and you will be able to weather any storm that may be on the horizon.

Now you know.

-Suze.

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How Fannie and Freddie Work.

Both Fannie and Freddie Mac provide money for mortgages, either by raising money themselves that is then lent out as loans, or by buying mortgages that banks make. With a hand in 50% of American mortgages, Fannie and Freddie have a huge impact on the mortgage markets as well as the broader financial markets.

I bet it would help to understand the flow of money in the mortgage world.

When you apply for a mortgage, the lender (a bank) needs to be able to float you that money. One way the bank does this is to look at its balance sheet and see how much money it has on deposit; the deposits you and I make in our checking accounts and CDs etc. provide the capital for banks to make loans, including mortgages. Then the bank offsets lending out that money by collecting the mortgage payments from the borrower.

At least that’s the old-fashioned way banks made mortgage loans. And in fact, a few banks still continue to lend money with the intention of holding onto the mortgage and collecting the payments from the borrower.

But the more popular bank lending practice is to issue a mortgage and then immediately turn around and sell that loan to Fannie or Freddie, or get the backing of Fannie and Freddie on the loan payment. The bank then gets paid by Fannie and Freddie, which gives the bank more capital to lend or invest, but it doesn’t have the mortgage to worry about.

Fannie or Freddie now has that mortgage. And they take the mortgage and combine it with thousands of other mortgages and package it as a debt security (a bond) where investors are paid interest from the interest you, the home owner, are paying on the loan.

So you got your mortgage, the bank made money making the loan to you, and selling it to Fannie or Freddie. And then Fannie and Freddie make money by repackaging mortgages into securities investors pay them for.

So where’s the problem? Well, when Americans run into mortgage trouble and can’t keep up with their payments, or walk away from their loan, the bonds Fannie and Freddie issued that were backed by your mortgage payments, don’t receive the payouts they expected. The ball has started to roll in the wrong direction.

The early response to this problem months ago was to get Fannie and Freddie to shore up their finances by going out into the credit market and raising more money to help make those payments. That worked for a brief moment-Fannie was able to raise more capital a few months ago. But by late July no one-meaning big financial institutions and foreign governments-was willing to loan money to either Fannie or Freddie. Think of it this way: investors looked at Fannie and Freddie and decided they had a really lousy FICO credit score. And in these tough times, who wants to take a risk on a lousy credit risk? And that’s what got us to Sept. 7th: recognizing that Fannie and Freddie couldn’t raise money to stay in business, the government stepped in. And the “capital” it will use to shore up both entities will eventually be paid by U.S. taxpayers.

* The FDIC insurance increase to $250,000 is temporary at this point—only valid through DECEMBER 31, 2009.