Problems at Fannie Mae, Freddie Mac ripple outward

Even if the twin giants of America's mortgage industry don't end up needing a taxpayer bailout, the troubles of Fannie Mae and Freddie Mac have big implications for ordinary Americans.

It's not an exaggeration to say that the cost of mortgages, home prices, and even the health of the broader economy hangs to some extent on these mammoth providers of credit. Together, Fannie and Freddie account for about half of outstanding home financing in the nation.

Now, with the housing market in deep downturn, shareholders have been bailing out as they look at the financial risks these firms face. The tougher their road gets, the higher it may push mortgage costs – possibly delaying any recovery in real estate.

Officials worked overtime Friday in an effort to calm a sense of panic. Experts generally say neither Fannie nor Freddie is on the brink of insolvency. But it appears that, at a minimum, they'll need a a private-sector solution – a new infusion of capital from investors – to weather the housing storm.

"They're clearly in deep trouble," says Mark Zandi, chief economist at Moody's Economy.com in West Chester, Pa. "It does highlight the severity of the housing downturn.... Even Fannie's and Freddie's borrowers are in trouble."

The two corporations didn't make many of the so-called subprime loans that have had the highest rate of default as the housing boom imploded over the past two years. Fannie and Freddie are private entities, but they have federal charters to help ensure a stable housing market by guaranteeing mortgages or buying mortgages from other lenders.

Now the government is looking to these firms to keep mortgage credit flowing at a time when other funding sources have dried up.

But in recent months Fannie and Freddie have been losing money, and this week investor pessimism tipped over an edge. The concern: that the firms don't have adequate capital to cover ongoing losses.

One possible result would be a scramble to issue new shares, which would dilute the value of current shares. Another more dire outcome could be a government bailout, where again current shareholders might lose out.

Some experts say it's far from clear that such a rescue will be needed.

"We are not in a crisis at this point," says Susan Wachter, a finance expert at the University of Pennsylvania's Wharton School. "This is a moment of lack of confidence."

Still, she says the financial headwinds facing Fannie and Freddie have already been pushing up mortgage interest rates for all Americans.

"It makes mortgages more expensive and harder to get," she says. If the financial picture weakens, that negative effect could increase.

Still, the picture is not one of Armageddon, she says. One way or another, these so-called government sponsored enterprises (GSEs) will keep functioning, even if it requires some government help.

"The implicit government guarantee will keep mortgage markets functioning," Ms. Wachter says.

But even if credit flows as normal, stress at the GSEs has consequences for the mortgage market, banks, and the economy.

If it's harder or more expensive to get loans, that challenges a housing market that already has larger than usual inventories of homes for sale. It pushes home prices down, because homebuyers will have to spend more of their available money on the loans themselves.

"This certainly delays the day when the housing market turns the corner," Mr. Zandi says.

Economists warn of a feedback loop in which rising unemployment, tight credit, and falling home prices become self-reinforcing trends. A delayed recovery in the housing market puts more financial pressure on the GSEs and on mainstream banks alike.

"You may not want to let this drag on," says Zandi, suggesting that more policy steps are needed to slow the pace of mortgage foreclosures.

As Fannie and Freddie saw their stock price sink, Congress was considering a measure designed to allow many at-risk loans to be refinanced rather than going into default.

But stock-price moves have pushed questions surrounding the GSEs to the forefront.

"Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission," Treasury Secretary Henry Paulson said Friday.

"Fannie and Freddie are too important to fail. Their fundamentals, as they look now, provide no reason to think they will fail," Sen. Charles Schumer (D) of New York said in a statement.

"There is more than one way to shore up Fannie and Freddie if necessary," he added. "There are countless intermediate steps that regulators could take before ever having to entertain a government takeover."