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Experts differ on whether the $700 billion bailout plan will prompt banks to lend and help the economy. But even if it does, it will take time.

Bailout: What's next

 

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The goal is to unfreeze the credit markets. Financial institutions have become paralyzed with fear and though they have plenty of cash on hand, they've been hoarding it. Without this intra-bank lending, businesses are having trouble getting the financing they need even for daily operations, much less loans for longer-term projects.

"Hopefully, this will lend a calming effect to the markets," said Joe Belew, president of the Consumer Bankers Association. "We need to take a deep breath, relax and start doing business again."

Don't expect lending to ramp up overnight, however. It may take weeks for confidence to return, experts said. Or even longer.

The centerpiece of the bill allows the government to eventually buy up to $700 billion in assets tied to shaky mortgages. Getting the bad paper off banks' balance sheets hopefully will give institutions more confidence to start lending again. (Bailout 101: What the new law says)

Treasury Secretary Henry Paulson has up to 45 days to devise a plan to purchase the assets.

But one big question is what the Treasury Department will pay for those assets. Too low a price - which is good for taxpayers - and banks may find they still need to take steps to shore up their balance sheets. Some may have to raise additional capital, which has been scarce in this tumultuous market. Investors may remain on the sidelines for a while until things shake out, experts said.

The plan's passage did little to allay fears in the stock market, which sold off once the House approved the bill. Investors, who remain skittish that the bailout plan will achieve its goals, sent the Dow Jones industrial average down 1.5%.

"Thaws take time," said Diane Casey-Landry, chief operating office of the American Bankers Association, noting that the bailout plan won't instantly eliminate all concerns. "We'll be in the Ronald Reagan mode of 'Trust but verify'."

Even President Bush told Americans to have patience. "Americans should also expect that it will take some time for this legislation to have its full impact on the economy," he said. "With a smoother flow of credit, more businesses will be able to stock their shelves and meet their payrolls. More families will be able to get loans for cars and homes and college education. More state and local governments will be able to fund basic services."

Plenty of other problems

Many economists, however, say the president and other supporters of the bailout were painting too rosy a picture.

Until the tidal wave of foreclosures ends and home values stop their stomach-churning drops, banks will remain reluctant to lend and the economy won't improve, experts said.

"This bill doesn't contain any element of stability for the housing market or the real economy," said Christian Menegatti, lead analyst for economic research firm RGE Monitor. "The problems are going to come back and the lack of confidence will come back."

In fact, nearly one in three financial services executives said they expect credit standards to continue to tighten even if the bailout plan is approved, according to a Deloitte poll taken Thursday. So it will still be tough to get a mortgage or small business loan.

"We're back to more normal underwriting standards," Casey-Landry said. "People will need to have good credit to get a loan."

Consumers, business won't want to spend

As long as the constant drumbeat of bad economic reports continues, consumers and businesses may not be so eager to borrow money anyway even if banks start extending more credit. Friday's dismal jobs report, showing that 159,000 people lost their livelihoods, did little to inspire people to spend.

"You tell me I can have the credit, but I don't want it," said Amiyatosh Purnanandam, assistant professor of finance at the University of Michigan. "If people are not going to buy cars whether they can get credit or not, it's not going to help the economy."

This becomes a vicious cycle. If consumers don't spend, the economy fails to improve. The jitters may return to the financial markets, prompting another government intervention.

That's why many fear the $700 billion rescue may not be the last step.

The move, which extends as much as $200 billion in Treasury support to the two companies, marks Washington's most dramatic attempt yet to shore up the nation's housing market, which is suffering from record foreclosures and falling prices.

The sweeping plan, announced by Treasury Secretary Henry Paulson and James Lockhart, director of the Federal Housing Finance Agency, places the two companies into a "conservatorship" to be overseen by the Federal Housing Finance Agency. Under conservatorship, the government would temporarily run Fannie and Freddie until they are on stronger footing.

"A failure [of Fannie and Freddie] would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance," Paulson said at a press conference in Washington. "And a failure would be harmful to economic growth and job creation."

Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500), which were created by the U.S. government, have been badly hurt in the last year by the sharp decline in home prices as well as rising mortgage delinquencies and foreclosures. All told, the two firms have racked up about $12 billion in losses since last summer.

On Sunday, officials stressed that both Fannie and Freddie will be open for business on Monday morning, although the firms will have undergone a dramatic facelift by then.

Freddie CEO Richard Syron and Fannie CEO Daniel Mudd will no longer run the agencies, while the FHFA will assume control of the boards. Regulators took care not to foist blame on the two executives, adding that they would stick around to help with the transition.

Syron and Mudd will be replaced by two finance veterans charged with restoring the mortgage titans to health. Herb Allison, the former chairman and CEO of pension provider TIAA-CREF, will head Fannie Mae. Allison formerly served as president of Merrill Lynch.

David Moffett, who served as vice chairman and chief financial officer of U.S. Bancorp until early 2007 and then joined the Carlyle Group private-equity firm as a senior adviser, will take over Freddie Mac.

At the same time, dividends on both common and preferred shares will be eliminated in an effort to conserve about $2 billion annually. All of the firms' lobbying and political activities will be halted immediately and charitable activities reviewed.

In addition, the Treasury Department announced a series of moves targeted at providing relief to both housing and financial markets.

Paulson said Treasury would boost housing by purchasing mortgage-backed securities from Freddie and Fannie, as well as offering to lend money to the companies and the 12 Federal Home Loan Banks. The home loan banks advance funds to more than 8,000 member banks. (Read what Paulson said.)

The Treasury, with fellow regulator FHFA, will also buy preferred stock in Fannie and Freddie to provide security to the companies' debt holders and bolster housing finance.

The government, in agreeing to backstop the firms, said it would receive $1 billion in each company's senior preferred stock. The government will also receive a quarterly dividend payment and the right to own 79.9% of each company.

Sunday's announcement brings an end to months of speculation about the fate of the two firms. Shares of Fannie and Freddie, which have fallen more than 80% as of the end of Friday's session, were hammered this summer among concerns they would need to raise additional funds to cover future losses or need to be taken over by its federal regulator. Investors feared that either step would reduce or wipe out the value of current shareholders' stakes.

In mid-July, the Treasury Department and Federal Reserve announced steps in to make funds available to the firms if necessary and Congress approved the sweeping proposals later that month.

Shortly thereafter, regulators stepped up their review of Fannie and Freddie. Paulson announced in August that he had tapped Wall Street firm Morgan Stanley (MS, Fortune 500) to help him examine the firms.

Sources familiar with the matter told Fortune that Morgan Stanley had determined that both Freddie and Fannie faced "meaningful" capital issues before deciding last week that government intervention was necessary. Morgan Stanley has called a firm-wide meeting on Monday morning to explain the deal.

Officials ruled out a capital infusion - a less drastic option than convervatorship - after considering questions such as whether the government would have to keep putting money in and how best Treasury officials could protect taxpayers, according to one of the sources.

In the end, the route taken amounts to "a timeout, not a liquidation," says the source. "Conservatorship leaves all options open for the next administration."

Following an exhaustive review, FHFA's Lockhart said Sunday that the two companies could not continue to operate without taking "significant action."

Fannie and Freddie have become virtually the only source of funding for banks and other home lenders looking to make home loans. Their ability to do so is crucial to the recovery of the battered home market and the broader U.S. economy.

The two firms buy loans, attach a guarantee, then sell securities backed by the loans' income stream. All told, they own or back $5.4 trillion worth of home debt - half the mortgage debt in the country.

The Treasury-FHFA plan, which was widely anticipated after financial markets closed on Friday, drew praise from regulators, lawmakers and some market experts.

President Bush called the move "critical" to the housing market recovery. "Americans should be confident that the actions taken today will strengthen our ability to weather the housing correction and are critical to returning the economy to stronger sustained growth in the future," he said.

Federal Reserve Chairman Ben Bernanke, who along with Paulson has led efforts to help get the U.S. housing market and the broader economy back on track, endorsed the move by Lockhart and Paulson.

"These necessary steps will help to strengthen the U.S. housing market and promote stability in our financial markets," Bernanke said in a statement.

Sen. Charles Schumer, D-N.Y., a member of the Senate Banking Committee, said that Paulson had "threaded the needle just right" with the plan, noting that it will likely be met with praise from other lawmakers.

At first blush, Wall Street seemed encouraged by the news, although the true test will come when financial markets around the globe open Monday. Pimco's Bill Gross, a widely followed bond fund manager, said that the Freddie-Fannie plan was the right move.

"This is a significant step and almost exactly what we had hoped for," Gross told CNNMoney.com Sunday.

In addition to confirming the government's sovereign credit rating, Standard & Poor's affirmed its sterling AAA rating on both Fannie Freddie on the news, adding that its outlook for the two firms is stable.

The cost of the government intervention remains unclear however. Experts argue that it will depend in large part on the structure of the rescue, the direction of home prices and mortgage default rates.

Still it seems almost certain it will run into the billions and will most likely eclipse such other high-profile government bailouts including than the Federal Reserve's $29 billion backing of Bear Stearns assets when it was taken over by J.P. Morgan Chase.

Paulson said that the cost to taxpayers would largely depend on the future financial performance of Fannie and Freddie.

Another unintended yet unavoidable consequence may be the impact to the nation's banks.

Some of the nation's largest financial institutions including JPMorgan Chase (JPM, Fortune 500) and Sovereign Bancorp (SOV, Fortune 500) own a big chunk of the estimated $36 billion in preferred shares of Fannie and Freddie, according to research published last month by Keefe, Bruyette & Woods, an investment bank that specializes in financial firms. Those stakes are at risk of being wiped out as a result of Sunday's announcement.

Top banking regulators, including the Federal Reserve as well as the Federal Deposit Insurance Corp., said in a joint statement Sunday that a limited number of smaller institutions have significant preferred share holdings in Fannie and Freddie. They added they are prepared to work with these institutions to come up with a plan should they need to raise capital.

Still, the rescue of Fannie and Freddie could go a long way toward its intended aim - bringing stability to the housing market while making it easier for consumers to obtain affordable mortgages.

An earlier version of this article incorrectly stated that the government would invest $1 billion in each company's preferred stock.

--CNNMoney.com senior writer Tami Luhby and Fortune editor at large Patricia Sellers contributed to this report. 

NEW YORK (CNNMoney.com) -- When it comes to rescuing Fannie Mae and Freddie Mac, there's not likely to be any middle ground.

Treasury Secretary Henry Paulson hopes he'll never have to use the unlimited authority he has just received to bail out the mortgage giants. If he's right, the cost to taxpayers will be zero.

But if Treasury does have to rescue Fannie and Freddie, it's likely to cost far more than the current estimate of $25 billion - even well beyond the $100 billion worst-case-estimate from the Congressional Budget Office.

Fannie and Freddie, which have charters with the government, are instrumental to the mortgage process since they provide funding to banks by purchasing pools of home loans and packaging them as securities.

Shares of the two companies have each plunged about 50% in the past month, raising fears about whether they have enough capital to deal with losses brought on by further declines in home prices.

But even if just one of the firms needs to turn to Treasury to borrow money or sell stock in order to raise more capital, the market reaction could be swift. And it would likely start both firms down an inevitable road to a government takeover.

"If one goes down it's likely to so spook the market that it will bring the other one down as well," said Jaret Seiberg, financial analyst for the Stanford Group, a research firm.

If that were to occur, taxpayers will be on the hook for huge losses on the $5 trillion in mortgage-backed securities the two firms either own or guarantee. So the cost of a government rescue of Fannie and Freddie is almost certain to soar well beyond last week's official $25 billion cost estimate.

The CBO came up with its estimate based on the likelihood of different scenarios. The CBO said it believed there was a better than 50% chance that no rescue would be needed. Thus, it wouldn't cost taxpayers anything.

However, the CBO also said there was about a 5% chance of a rescue that would cost taxpayers "more than $100 billion" because of the need to cover losses at the firms.

Some experts believe the probability of a full-blown takeover is much higher than the CBO's 5% estimate.

Dan Seiver, a finance professor at San Diego State, said he thinks Fannie and Freddie will run into more financial problems "because the housing market hasn't bottomed out yet."

As a result, he believes "their essential independence from the federal government will disappear and they'll become government entities."

Just how much assistance, if any, Fannie and Freddie may ultimately need could come into clearer focus next month after the two firms report their latest financial results.

Fannie hasn't announced a date for its second-quarter report yet but Freddie will release its second quarter results on Aug. 6.

The two companies have lost a combined $12 billion during the past three quarters, mainly due to write-downs in the value of their combined $1.5 trillion portfolio of mortgage backed securities.

Analysts expect losses for both firms to continue through this year, according to Thomson Reuters. And some analysts believe second quarter losses for Fannie and Freddie could top the losses from the first quarter.

Victoria Wagner, the chief credit analyst for the firms at credit rating agency Standard & Poor's, said Fannie and Freddie are likely to post record losses from defaults and foreclosures on mortgages they own or guarantee.

S&P put Fannie and Freddie on credit watch last week, meaning it is considering whether to downgrade their debt. Still, Wagner said it's too soon to predict whether Fannie or Freddie will need a bailout.

"Our belief is still they should be able to manage through the cycle," she said.

Spokespeople for Fannie and Freddie wouldn't answer questions about whether they could get direct government help and still stay independent.

"We do not believe this will ever happen, so we're not going to speculate if this did happen, what the next step might be," said Freddie spokeswoman Sharon McHale.

Treasury Department spokeswoman Jennifer Zuccarelli also did not want to speculate about whether the government would have to take over the firms should direct help from Treasury become necessary.

She did reiterate, however, that the Treasury Department "is interested in keeping Fannie and Freddie in their current shareholder-owned form." 

NEW YORK (CNNMoney.com) -- President Bush on Wednesday signed into law a sweeping housing bill that aims to boost the struggling housing market and bolster mortgage finance giants Fannie Mae and Freddie Mac.

The Senate voted 72-13 in favor of the bill on Saturday, after the House passed it three days earlier.

"We look forward to put in place new authorities to improve confidence and stability in markets, and to provide better oversight for Fannie Mae and Freddie Mac," said White House spokesman Tony Fratto. "The Federal Housing Administration will begin to implement new policies intended to keep more deserving American families in their homes."

The new law, one of the most far-reaching on housing in decades, marks the centerpiece of Washington's efforts to address the nation's housing meltdown.

The legislation has two principal objectives: to offer affordable government-backed mortgages to homeowners at risk of foreclosure, and to bolster Fannie and Freddie with a temporary rescue plan and a new, more stringent regulator.

The White House last week reversed its long-standing threat to veto the bill. In fact, the administration still objects to parts of the legislation, including aid to states to buy foreclosed properties.

But the president decided to sign it since "oversight of the housing government sponsored enterprises (GSEs) and the new temporary authorities requested by [Treasury] Secretary [Henry] Paulson are urgently needed now, and they'll contribute to confidence and stability in housing and financial markets," Fratto said last week.

Provisions that will most directly affect consumers and communities include:

A larger role for the Federal Housing Administration. The FHA will be allowed to insure up to $300 billion in new 30-year fixed-rate mortgages for at-risk borrowers in owner-occupied homes if their lenders agree to write down loan balances to 90% of the homes' current appraised value.

The cost of the new FHA program - which would begin on Oct. 1 and be in place for just a few years - will be funded by fees from Fannie and Freddie, along with fees paid by both lenders and borrowers.

While the law authorizes the FHA to insure up to $300 billion in loans, the CBO estimates that the agency is only likely to insure up to $68 billion and help keep roughly 325,000 people in their homes. Those estimates were based on the CBO's assessment of who is likely to qualify under the program and accounts for a certain number likely to default anyway.

(Here are more details on this provision.)

A stronger regulator for the GSEs. The new regulator will have a greater say over how well funded the two government sponsored enterprises (GSEs) are - a major concern in the markets that has sent stocks in both companies plunging in the past two months.

A permanent increase in "conforming loan" limits. The law will permanently increase the cap on the size of mortgages guaranteed by Fannie and Freddie to a maximum of $625,500 from $417,000.

The FHA maximum loan limits for high-cost areas would also increase to a maximum of $625,500. Higher loan limits will make it easier for borrowers to get mortgages, because those mortgages are more likely to be traded if they are considered conforming.

A new home-buyer credit. The new law includes a tax refund for first-time home buyers worth up to 10% of a home's purchase price but no more than $7,500.

The refund, however, serves more as an interest-free loan, since it would have to be paid back over 15 years in equal installments.

A ban on down-payment assistance from sellers. The new law eliminates a program that has allowed sellers to provide down payment assistance for FHA loans.

The law would also increase to 3.5% from 3% the down payment requirement for borrowers getting FHA loans.

A new affordable housing trust fund. The law establishes a permanent fund to promote affordable housing. The fund will be paid for by fees from Fannie and Freddie.

Grants to states to buy foreclosed properties. The law grants $4 billion to states to buy up and rehabilitate foreclosed properties. The White House has opposed such funding, contending that it will benefit lenders and not homeowners.

A late and controversial addition to the new housing law provides temporary authority for the Treasury to lend a financial hand to Fannie Mae and Freddie Mac if the Treasury deems it necessary to help stabilize markets.

Concerns over whether Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) will have enough money to weather future losses in the housing market has sent shares plummeting in recent weeks. Since the beginning of June, Fannie's stock price has dropped 55% and Freddie's plummeted 64%. For the past year, they're both down over 80%.

Fannie and Freddie guarantee the purchase and trade of mortgages and own or back $5.2 trillion in mortgages.

The law includes provisions that let Treasury offer Fannie and Freddie an unlimited line of credit and buy stock in the companies. The provisions expire in 18 months.

Both critics and supporters of the Paulson plan have expressed concern that loaning or investing money in the companies could leave taxpayers with a fat bill to pay.

Treasury Secretary Paulson has said that merely having the powers in place may boost confidence in the two companies enough to preclude the need for Treasury to step in.

The Congressional Budget Office last week estimated the potential cost of a rescue could be $25 billion. CBO said there is probably a better than 50% chance that Treasury would not need to step in. It also said there is a 5% chance that Freddie's and Fannie's losses could cost the government $100 billion. 

Traditionally, when home buyers signed on for a mortgage, they had one option: A 30-year mortgage with a fixed interest rate. During the past decade, adjustable-rate loans rose (and fell). Now, with savvier home buyers who are more eager to pay off loans quickly, the 15-year mortgage has gained in popularity, especially for refinanced home loans.

Home mortgages come in all shapes and sizes, from loans with 40- or 50-year terms to seven-year refinance loans designed for homeowners with a small balance. Following recent scandals about suspect lending practices that have resulted in a rash of foreclosures, lenders are making it tougher to qualify for a mortgage. Find the best loan for your purposes by asking yourself:

1. What payment can you afford? The mortgage industry is cracking down on bad lending practices such as misuse of prepayment penalties, low-documentation loans that allow or encourage borrowers to borrow more than they can pay, mishandled escrow accounts and too-high debt-to-income ratios that put a borrower's financial security at risk. But still be aware that you might be offered a mortgage with a higher payment than you are comfortable making. Choose a home loan amount with payments you believe are affordable, whatever the term.
2. How long will you own the home? If you are sure you will stay in the home for only a few years, the loan term may matter less. Choose the product with the best up-front terms. On the other hand, if you intend to keep the home for many years, decide whether you prefer somewhat higher payments knowing the loan's end is relatively near, or easier payments that go on for a longer period. Also consider your family's life stage. If a 15-year loan would mean mortgage payments would end just as your firstborn heads to college, the timing might make a shorter loan worthwhile.
3. How important to you is total interest paid? On a home loan of $160,000, a 30-year mortgage at 7 percent annual interest would result in more than $223,000 in interest payments over the life of the loan. In contrast, a 15-year mortgage at the same rate costs less than $99,000 in interest! Clearly, the savings in interest and in time makes shorter home loans appealing to many borrowers. But if you choose the longer-term loan, take heart -- the additional interest you pay is tax deductible.
4. How disciplined are you? Many people argue that a 15-year mortgage and a 30-year mortgage can be made essentially the same. They believe homeowners should obtain a 30-year mortgage and then make extra principal payments every month. For a mortgage amortized over 30 years, making one extra principal and interest payment per year will pay off the loan eight years sooner. (Divide one principal and interest payment by 12, and add that amount to the monthly mortgage payment to total one extra payment over the course of the year.) If you hope to pay your mortgage off early, do you have the discipline to stick with your payment plan?
5. How much flexibility do you need? An advantage to a longer-term loan is that the payments are lower. On the same loan mentioned in #3 -- used to purchase a $200,000 home with 20 percent down -- the payment on a 30-year mortgage is $375 less per month than the payment for a 15-year loan. Even if you can afford the shorter loan, choosing a 30-year term and paying an additional $375 principal each month leaves the option of using that money elsewhere if it's needed in an emergency. Whichever you choose, it is a good idea to be sure the loan has no penalty for prepayment (paying the loan off early).
6. Do you have other debt you should pay off first? All things considered, a mortgage is relatively "good" debt. With every payment, you invest in your future. For most people, the interest is tax-deductible. And current home loan interest rates are fairly low. If you're like millions of Americans who owe thousands on credit cards -- with interest rates up to 20 percent or higher -- you would be wise to apply extra cash to paying off credit card debt before you focus on making additional payments on your mortgage loan.

Home borrowing has no one-size-fits-all solution. For the best outcome, take a clear view of your situation before selecting a mortgage product. Then be sure that whatever you choose, you make payments on time -- and enjoy your new home.