How Mortgages Work

Fannie Mae and Freddie Mac

Contrary to what you may think, mortgage lenders don't make their money on interest. They cash in your mortgage by selling it on the secondary investment market. If a lender had to wait 30 years to receive full payment on its mortgage loans, it wouldn't have enough liquidity to make loans to other borrowers.

The largest purchasers of mortgages on the secondary market are two government-sponsored enterprises (GSEs): the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These large public/private entities were created by Congress in order to make mortgages available to more people with low and moderate incomes.

For Freddie and Fannie (as they're commonly known) to purchase a mortgage, it must conform to their loan limits, which for 2010 were $417,000 for a single-family home in a "general" area and up to $1.8 million for high-cost areas like parts of Hawaii [source: Fannie Mae]. After Freddie and Fannie purchase mortgages from lenders, they sell them as securities in the bond market. This provides lenders with the liquidity to fund more mortgages, and until 2006, the mortgage-backed securities (MBS) sold by Freddie and Fannie were considered solid investments. But when hundreds of thousands of people began to default on their mortgages, those securities plummeted in value. Because so many large international investment banks had bet heavily on MBSs, the rising mortgage default rates in the U.S. sent shockwaves throughout the global economy.

In 2008, Fannie and Freddie were taken over by the Federal Housing Finance Agency, (technically, the FHFA became a "conservator" of the struggling mortgage backers) and as of June 2010 had received $145 billion in bailout funds from the U.S. Treasury to inject emergency liquidity into the credit market. Even after the government takeover, Fannie and Freddie were still publically traded companies until their share prices dipped below the minimum price requirements and were dropped from the New York Stock Exchange in 2010 [source: Reuters].

Even with all of their problems, Fannie and Freddie are still the largest purchasers of mortgages on the secondary market and an essential component of the nation's credit system.

On the next page, we'll talk about the "F" word -- foreclosure -- and how the government is helping beleaguered borrowers avoid a credit catastrophe.