Shares of mortgage giants Fannie Mae (FNM) & Freddie Mac (FRE) have dropped nearly 90% from their 52 week highs of $70.57 & $67.20 to $9.25 & $6.83.

Who are Fannie Mae and Freddie Mac?

The Federal National Mortgage Association (FNMA) also known as Fannie Mae is a government sponsored enterprise of the USfederal government. It was founded in 1938 as part of Franklin Delano Roosevelt’s efforts to provide liquidity to the mortgage market. In 1968, to remove the activity of Fannie Mae from the annual balance sheet of the federal budget, it was converted into a private corporation.

To end the monopoly Fannie Mae held in the secondary mortgage market, the Federal Home Loan Mortgage Corporation (FHLMC) also known as Freddie Mac was created in 1970.

These two companies play a pivotal role in the mortgage marketplace. They don’t make mortgages. They buy mortgages from originating banks and repackage them as bonds or keep them on their own balance sheets. Together they touch over $5 trillion in mortgages.

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How do they make money? They charge a guaranteed fee on loans that have been purchased and securitized into mortgage backed securities. In return for the fee, Fannie Mae & Freddie Mac assume the credit risk on the loan.

Both companies were perceived as too big to fail (due to their government sponsored status) and operated on a highly leveraged basis. Their combined core capital is approximately $70 billion which pales in comparison to the some $5 trillion in loans guaranteed or held by Freddie and Fannie.

In simple terms, they don’t have enough capital to handle the growing number of troubled mortgages they own or guarantee.

While the Federal Reserve and the Treasury announced steps to shore up the two mortgage giants, it remains to be seen what will come from it.

If there’s one fact we have learned from the tech meltdown in 2000 and the recent financial crisis, it is that things are always worse than initially disclosed.

The silver lining for ETF investors is that the direct damage to ETFs is very limited. Only one ETF, the PowerShares RAFI Financial Sector Portfolio (Ticker: PRFF) counts Fannie Mae as a top 10 holding. PRFF is a fundamentally weighted ETF, which allows for a higher weighting of Fannie Mae.

Fundamental weighting, by some, is touted as the best and most effective way of weighting components within an index and/or ETF. This claim is largely founded on back-tested data. Based on actual numbers; the PowerShares RAFI Financial Sector Portfolio (Ticker: PRFF) is down 41.36% YTD while the Financial Select Sector SPDRs (Ticker: XLF) and Vanguard Financials ETF (Ticker: VFH) are down “only” 39.58% and 36.14%

The exposure of old-fashioned, market cap weighted ETFs to FNM & FRE tends to be less than 1%. The Financial Selects Sector SPDRs (Ticker: XLF) hold 0.74% in FNM and 0.33% of their assets in FRE.

Over 100 mutual funds count either FNM or FRE as a top 10 holding. The Fidelity Select Home Finance Fund (FSVLX) has 10.88% invested in FNM and not surprisingly tumbled 62.48% in the past year.

The indirect ripple-effect of the financial meltdown is felt by all investors alike. Only proper diversification across ALL asset classes has guided a few smart investors to neutral or positive returns.

ETFguide’s Capital Defense Portfolio is up over 4%.
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Just because you have access to water, sugar and food coloring does not mean you know how to make Coca Cola. The right mix of ETFs is priceless!

Data as of 07-15-2008