Summary
Fannie and Freddie hold mortgages, which in turn are financed by bond issuances. With these subsidies, Fan/Fred will actually save a lot of dead-weight foreclosure costs. Unfortunately, Mark-to-Market Rules put Fan/Fred in a strange accounting trade-off.
Analysis
Think of it as getting a flu shot
When you get a flu shot, you may actually get a very low grade case of the flu. That doesn't mean getting a flu shot is a bad thing -- indeed, flu vaccinations have saved countless dollars of lost-work and probably many lives.
In very simple terms, Fan/Fred buy conforming mortgages (generally NOT sub-prime) and sell debt obligations to finance them. Generally, these mortgages either have substantial down payments or some kind of mortgage insurance. Fan/Fred have fairly good underwriting standards, and so they've not really been hurt that badly by the sub-prime melt-down.
Where Fan/Fred have been hurt is a combination of two things. First, in a recession -- particularly one where housing prices have declined dramatically -- even well-underwritten non-sub-prime mortgages are going to have problems. Second, mark-to-market rules require that they make certain write-downs today even if those write-downs will reduce losses in the future.
Corporations do this all the time, by the way. Investors are constantly reading about companies shutting down a division and taking a material write-off against current period earnings. Corporations do this to time tax losses (against periods of high taxable income) and to minimize future losses which, in a present value sense may be much higher.
In a frictionless world, with cost-less recontracting (the sort of world economists uses to create theories), Fan/Fred would simply renegotiate the mortgage-backed bonds to a lower -- or floating -- interest rate which would match the new interest rate charged to the home borrowers. All would be right with the world, and Fan/Fred's books would look approximately the same as they did yesterday.
In the real world, this sort of re-contracting would be horrendously expensive, even though it would be in the best interests of the end-bond-holders by reducing the long-run default and foreclosure costs.
Thus, Fan/Fred sit in the middle absorbing the losses. In the end, it's still a pretty smart thing to do, since dead-weight delinquency and foreclosure costs benefit no one except the call centers in Mumbai who make those ubiquitous phone calls to delinquent borrowers. However, by essentially hitting the reset button on the asset side, without a corresponding reset on the debt side of the ledger, Fan/Fred are caught in the middle with current-period mark-to-market losses.
