Too Big to Fail? Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are Apparently Too Big to Shrink

Last week, the government pledged essentially unlimited support to Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), in an effort to ensure the housing market does not unravel further.

Through this effort, the Treasury Department has ensured that mortgage rates will stay low, and this should be a boon for economic activity as we enter the new year. Consumers, seeing the seeds of a rebound, may be prompted to buy new homes, and will be able to take advantage of these artificially low rates. Banks should experience strong profits, as they will be able to sell these conforming loans to Fannie and Freddie.

This action will cover losses experienced by the mortgage giants through 2012, allowing the companies investment portfolios to grow, and implementing a safety net at the same time. In September 2008, the Bush administration’s plan was aimed at shrinking the size of the companies’ holdings of mortgage backed securities.

What a difference a year makes. Just a year ago, the key concern was the toxicity of these loans, but now, the goal seems to be to give out as many new loans as possible, without regard to credit quality. This action did not require approval by Congress, and will likely allow Fannie and Freddie to become more aggressive in the housing market. Edward Pinto, a housing consultant who served as Fannie Mae’s chief credit officer in the later 1980’s commented “They’ve cleared the decks to use Fannie and Freddie as a vessel for whatever they want.”

As the refinance activity has not helped to stem the national foreclosure mess, the Treasury could also lean on Fannie and Freddie to help homeowners avoid foreclosures, and prompt a new wave of refinancing.

Fannie Mae and Freddie Mac finance three quarters of all new mortgages – so, last year’s plan to shrink their book would have disastrous consequences. Although their risk profile would certainly lower, the effects on consumers would be massive. The Treasury Department says its only motivation is to make sure investors remain confident that Fannie and Freddie can keep doing their jobs of buying the bulk of mortgages made in the U.S. and turning them into investments.

Who would actually buy these investments is yet to be seen. Fannie and Freddie must convince everyone from the Chinese central bank to hedge funds to individual investors that it is still safe to buy their debt securities, which they sell partly through weekly auctions. The two firms have sold $2.7 trillion in debt this year, according to Credit Suisse calculations. Giving out loans is one thing, being able to sell them is a different issue altogether.