How Fannie and Fredie work.

The federal government seized control of Government Sponsored Entities (GSEs) Fannie Mae and Freddie Mac on Sunday. The take over is an attempt to quell investor fears and stabilize the housing market and the U.S. economy. The result may be just the opposite. Either way, the move has enormous implications for the livelihood of mortgage originators.

Fannie Mae and Freddie Mac were shareholder-owned corporations chartered by congress nearly four decades ago to expand the flow of mortgage funds, affordable housing, and security to the nation’s housing system. Fannie Mae and Freddie Mac together own over $5 trillion in home loans, which is half of the country’s mortgage debt.

It was set up to work like this: Home buyers borrow money from banks who then sell the mortgages to Fannie or Freddie who then bundle the loans and resell them as bonds to investors.

According to published reports by the Associated Press, "the role the two companies played in the U.S. mortgage market grew dramatically over the past year as other lenders collapsed under the weight of bad subprime loans. The companies guaranteed about three-quarters of all new mortgages in the second quarter of this year, up from under 40 percent in 2006."

Fannie and Freddie came under fire when the housing market crashed and investors began to see their bonds as risky. The two companies lost $14 billion in the last year alone with more losses piling up as home values continue to sink and defaults continue to pile up.

Back in July, the federal government announced that they would step in, should the need arise, and rescue the mortgage giants by 1.) Passing legislation that would extend lines of credit on a temporary basis over the current $2.25 billion limit from the Treasury to Fannie and Freddie; 2.) Giving the Treasury the option to buy equity in Fannie and Freddie; and 3.) Granting the Federal Reserve Bank of New York the authority to lend additional funds to the GSEs.

A few months ago, this precautionary plan seemed just that. Both Fannie and Freddie assured the public and their stockholders that they were “adequately capitalized". Federal Reserve Chairman Ben Bernanke stood before the House Financial Services Committee and assured them that Fannie Mae and Freddie Mac were in "no danger of failing" and that a lack of investor confidence in the housing market led to the GSE’s inability to raise capital which caused investors to get the jitters, stock prices to plunge, and the Fed to make their precautionary announcement.

However, that precautionary announcement didn’t do much to quell investor fears, particularly major foreign investors like the central banks of China and Russia. Fannie and Freddie stocks continued to go down and because of their inability to raise funds from the private sector, the mortgage giants - who were once viewed as the beacons of stability in the housing market - appeared to be standing on shaky ground. On top of this, recent housing reports have gotten worse. On Friday, the Mortgage Bankers Association (MBA) reported that nearly one in ten homeowners are either delinquent or in some stage of the foreclosure process.

So, on Sunday, the federal government stepped in and took over by placing the two companies into a conservatorship which will be overseen by the Federal Housing Finance Agency (FHFA). This means that the FHFA will come in and run the companies until they are stable. It also means that they have cleaned house.

Richard F. Syron, Chairman and CEO of Freddie Mac, and Daniel H. Mudd, President and CEO of Fannie Mae, are out. They’ve been replaced by David Moffett and Herb Allison. Moffett, who will take the reins at Freddie, was formerly a senior advisor at the Carlyle Group and vice chairman and chief financial officer of U.S. Bancorp. Allison, who will head Fannie, is the former president of Merrill Lynch and the former chairman and chief financial officer of TIAA-CREF. The boards of both companies will be controlled by the FHFA.

The government expects that this move will give investors a “guarantee” that Fannie and Freddie will not fail and the U.S. housing market will recover. They’re hoping that with renewed faith and a sense of reduced risk and security, investors will re-inject funds back into the market.

It can go either way.

In the best-case scenario, investors will buy into the move hook, line, and sinker. More liquidity and stability will enable regulators to ease up on lending restrictions and bring more borrowers back into the market. Eased lending restrictions are the key to housing market recovery.

In the worst-case scenario, the market won’t buy into the move. Fannie and Freddie stock will continue to sink and the U.S. federal government – and ultimately U.S. taxpayers – will be left holding the bag. Regulators will be forced to tighten lending restrictions in order to prove to the market that they are still viable.

It’s going to take some time to determine just how investors are going to respond. Originators will be watching closely in the next few days or weeks to see how this plays out. Their livelihood and their industry hang in the balance.